Sociedad Química y Minera de Chile SA (NYSE:SQM) delivered an ROE of 17.37% over the past 12 months, which is an impressive feat relative to its industry average of 13.96% during the same period. Superficially, this looks great since we know that SQM has generated big profits with little equity capital; however, ROE doesn’t tell us how much SQM has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether SQM’s ROE is actually sustainable. See our latest analysis for SQM
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs SQM’s profit against the level of its shareholders’ equity. It essentially shows how much SQM 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 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 SQM, which is 8.70%. This means SQM returns enough to cover its own cost of equity, with a buffer of 8.66%. This sustainable practice implies that the company pays less for its capital than what it generates in return. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from SQM’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable SQM’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check SQM’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 51.29%, 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? SQM’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of SQM 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%.