Codan Limited (ASX:CDA) delivered an ROE of 28.63% over the past 12 months, which is an impressive feat relative to its industry average of 10.79% during the same period. While the impressive ratio tells us that CDA has made significant profits from little equity capital, ROE doesn’t tell us if CDA has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether CDA’s ROE is actually sustainable. View our latest analysis for Codan
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs CDA’s profit against the level of its shareholders’ equity. It essentially shows how much CDA can generate in earnings given the amount of equity it has raised. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. CDA’s cost of equity is 9.83%. Since CDA’s return covers its cost in excess of 18.80%, its use of equity capital is efficient and likely to be sustainable. Simply put, CDA pays less for its capital than what it generates in return. ROE can be split up into three useful 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 CDA 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 CDA’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt CDA currently has. Currently, CDA has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
What this means for you:
Are you a shareholder? CDA’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.