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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
Johnson Controls International plc (NYSE:JCI) generated a below-average return on equity of 11.28% in the past 12 months, while its industry returned 13.16%. JCI’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on JCI’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of JCI’s returns.
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What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 11.28% implies $0.11 returned on every $1 invested. 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 Johnson Controls International’s equity capital deployed. Its cost of equity is 9.93%. Johnson Controls International’s ROE exceeds its cost by 1.35%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than Johnson Controls International’s case of positive discrepancy. ROE can be broken down into three different 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. The other component, asset turnover, illustrates how much revenue Johnson Controls International can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Johnson Controls International’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a reasonable 54.25%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.