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Andritz AG (WBAG:ANDR) outperformed the Industrial Machinery industry on the basis of its ROE – producing a higher 20.04% relative to the peer average of 13.78% over the past 12 months. On the surface, this looks fantastic since we know that ANDR has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable ANDR’s ROE is. See our latest analysis for Andritz
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Andritz’s profit relative to its shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.2 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Andritz’s equity capital deployed. Its cost of equity is 9.84%. Since Andritz’s return covers its cost in excess of 10.20%, its use of equity capital is efficient and likely to be sustainable. Simply put, Andritz pays less for its capital than what it generates in return. ROE can be dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
Dupont Formula
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Andritz can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Andritz’s historic debt-to-equity ratio. At 65.93%, Andritz’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Andritz’s above-industry ROE is encouraging, and is also in excess of its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.