Loblaw Companies Limited (TSX:L) delivered an ROE of 13.12% over the past 12 months, which is an impressive feat relative to its industry average of 11.81% during the same period. While the impressive ratio tells us that L has made significant profits from little equity capital, ROE doesn’t tell us if L has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether L’s ROE is actually sustainable. View our latest analysis for Loblaw Companies
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Loblaw Companies’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 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 Loblaw Companies, which is 8.43%. This means Loblaw Companies returns enough to cover its own cost of equity, with a buffer of 4.69%. 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. The other component, asset turnover, illustrates how much revenue Loblaw Companies can make from its 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 Loblaw Companies currently has. At 88.73%, Loblaw Companies’s debt-to-equity ratio appears sensible 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? L’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%.