Dalhoff Larsen & Horneman A/S (CPSE:DLH) outperformed the Trading Companies and Distributors industry on the basis of its ROE – producing a higher 9.56% relative to the peer average of 5.57% over the past 12 months. While the impressive ratio tells us that DLH has made significant profits from little equity capital, ROE doesn’t tell us if DLH has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of DLH’s ROE. Check out our latest analysis for Dalhoff Larsen & Horneman
What you must know about ROE
Return on Equity (ROE) is a measure of Dalhoff Larsen & Horneman’s profit relative to its shareholders’ equity. For example, if the company invests DKK1 in the form of equity, it will generate DKK0.1 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
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 Dalhoff Larsen & Horneman, which is 9.27%. Since Dalhoff Larsen & Horneman’s return covers its cost in excess of 0.29%, its use of equity capital is efficient and likely to be sustainable. Simply put, Dalhoff Larsen & Horneman 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. Asset turnover shows how much revenue Dalhoff Larsen & Horneman can generate with its current 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 Dalhoff Larsen & Horneman’s historic debt-to-equity ratio. Currently, Dalhoff Larsen & Horneman 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.