The a2 Milk Company Limited (NZSE:ATM) delivered an ROE of 48.40% over the past 12 months, which is an impressive feat relative to its industry average of 11.75% during the same period. On the surface, this looks fantastic since we know that ATM has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether ATM’s ROE is actually sustainable. See our latest analysis for a2 Milk
Breaking down Return on Equity
Return on Equity (ROE) is a measure of a2 Milk’s profit relative to its shareholders’ equity. For example, if the company invests NZ$1 in the form of equity, it will generate NZ$0.48 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 a2 Milk’s equity capital deployed. Its cost of equity is 8.55%. This means a2 Milk returns enough to cover its own cost of equity, with a buffer of 39.85%. 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 shows how much revenue a2 Milk 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 ROE can be inflated by excessive debt, we need to examine a2 Milk’s debt-to-equity level. Currently, a2 Milk 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? ATM’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%.