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CSL Limited (ASX:CSL) delivered an ROE of 42.11% over the past 12 months, which is an impressive feat relative to its industry average of 16.12% during the same period. While the impressive ratio tells us that CSL has made significant profits from little equity capital, ROE doesn’t tell us if CSL has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable CSL’s ROE is. See our latest analysis for CSL
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.42 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for CSL, which is 8.55%. Given a positive discrepancy of 33.56% between return and cost, this indicates that CSL pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from CSL’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt CSL currently has. At 115.87%, CSL’s debt-to-equity ratio appears balanced and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
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ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. CSL exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.