MSC Industrial Direct Co Inc (NYSE:MSM) delivered an ROE of 19.92% over the past 12 months, which is an impressive feat relative to its industry average of 11.36% during the same period. While the impressive ratio tells us that MSM has made significant profits from little equity capital, ROE doesn’t tell us if MSM has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable MSM’s ROE is. View our latest analysis for MSC Industrial Direct
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 19.92% implies $0.2 returned on every $1 invested. 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
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 MSC Industrial Direct, which is 8.49%. Given a positive discrepancy of 11.43% between return and cost, this indicates that MSC Industrial Direct pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from MSC Industrial Direct’s 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 financial leverage can artificially inflate ROE, we need to look at how much debt MSC Industrial Direct currently has. At 43.50%, MSC Industrial Direct’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? MSM’s ROE is impressive relative to the industry average and also covers 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%.