In This Article:
I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
With an ROE of 12.45%, Australia and New Zealand Banking Group Limited (ASX:ANZ) outpaced its own industry which delivered a less exciting 11.83% over the past year. While the impressive ratio tells us that ANZ has made significant profits from little equity capital, ROE doesn’t tell us if ANZ has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable ANZ’s ROE is.
See our latest analysis for Australia and New Zealand Banking Group
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 12.45% implies A$0.12 returned on every A$1 invested. 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 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 Australia and New Zealand Banking Group, which is 8.55%. Since Australia and New Zealand Banking Group’s return covers its cost in excess of 3.90%, its use of equity capital is efficient and likely to be sustainable. Simply put, Australia and New Zealand Banking Group pays less for its capital than what it generates in return. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Australia and New Zealand Banking Group can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Australia and New Zealand Banking Group currently has. At over 2.5 times, Australia and New Zealand Banking Group’s debt-to-equity ratio is very high and indicates the above-average ROE is generated by significant leverage levels.