CVC Limited (ASX:CVC) delivered an ROE of 11.78% over the past 12 months, which is an impressive feat relative to its industry average of 8.70% during the same period. While the impressive ratio tells us that CVC has made significant profits from little equity capital, ROE doesn’t tell us if CVC has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether CVC’s ROE is actually sustainable. See our latest analysis for CVC

Breaking down Return on Equity

Return on Equity (ROE) weighs CVC’s profit against the level of its shareholders’ equity. For example, if CVC invests A$1 in the form of equity, it will generate A$0.12 in earnings from this. 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 CVC’s equity capital deployed. Its cost of equity is 8.55%. Since CVC’s return covers its cost in excess of 3.23%, its use of equity capital is efficient and likely to be sustainable. Simply put, CVC pays less for its capital than what it generates in return. ROE can be dissected into three distinct 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 CVC is with its cost management. The other component, asset turnover, illustrates how much revenue CVC can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine CVC’s debt-to-equity level. At 11.49%, CVC’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? CVC exhibits a strong ROE against its peers, as well as sufficient returns to cover 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%.

Are you a potential investor? If you are considering investing in CVC, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on CVC to help you make a more informed investment decision.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.