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PayPal Holdings Inc (NASDAQ:PYPL) generated a below-average return on equity of 13.13% in the past 12 months, while its industry returned 14.62%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into PYPL’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of PYPL’s returns. Check out our latest analysis for PayPal Holdings
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of PayPal Holdings’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.13 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 measured against cost of equity in order to determine the efficiency of PayPal Holdings’s equity capital deployed. Its cost of equity is 9.34%. While PayPal Holdings’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for PayPal Holdings which is encouraging. 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
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 shows how much revenue PayPal Holdings 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 financial leverage can artificially inflate ROE, we need to look at how much debt PayPal Holdings currently has. The debt-to-equity ratio currently stands at a low 20.49%, meaning PayPal Holdings still has headroom to borrow debt to increase profits.