With an ROE of 41.75%, Objective Corporation Limited (ASX:OCL) outpaced its own industry which delivered a less exciting 20.74% over the past year. Superficially, this looks great since we know that OCL has generated big profits with little equity capital; however, ROE doesn’t tell us how much OCL has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable OCL’s ROE is. Check out our latest analysis for Objective
What you must know about ROE
Return on Equity (ROE) weighs OCL’s profit against the level of its shareholders’ equity. It essentially shows how much OCL can generate in earnings given the amount of equity it has raised. 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 measured against cost of equity in order to determine the efficiency of OCL’s equity capital deployed. Its cost of equity is 9.18%. This means OCL returns enough to cover its own cost of equity, with a buffer of 32.57%. This sustainable practice implies that the company 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
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 OCL can make from its 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 OCL’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check OCL’s historic debt-to-equity ratio. Currently, OCL 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.
What this means for you:
Are you a shareholder? OCL’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 OCL 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%.