With an ROE of 20.61%, Adobe Systems Incorporated (NASDAQ:ADBE) outpaced its own industry which delivered a less exciting 12.98% over the past year. Superficially, this looks great since we know that ADBE has generated big profits with little equity capital; however, ROE doesn’t tell us how much ADBE has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable ADBE’s ROE is. Check out our latest analysis for Adobe Systems
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. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 Adobe Systems, which is 9.20%. Since Adobe Systems’s return covers its cost in excess of 11.41%, its use of equity capital is efficient and likely to be sustainable. Simply put, Adobe Systems 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. Asset turnover shows how much revenue Adobe Systems can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Adobe Systems’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 23.12%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? ADBE’s ROE is impressive relative to the industry average and also covers its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of ADBE to your portfolio if your personal research is confirming what the ROE is telling you. 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%.