MotorCycle Holdings Limited (ASX:MTO) delivered an ROE of 24.00% over the past 12 months, which is an impressive feat relative to its industry average of 13.11% during the same period. While the impressive ratio tells us that MTO has made significant profits from little equity capital, ROE doesn’t tell us if MTO has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable MTO’s ROE is. See our latest analysis for MTO
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs MTO’s profit against the level of its shareholders’ equity. An ROE of 24.00% implies A$0.24 returned on every A$1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. MTO’s cost of equity is 8.55%. Since MTO’s return covers its cost in excess of 15.45%, its use of equity capital is efficient and likely to be sustainable. Simply put, MTO 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue MTO can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable MTO’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine MTO’s debt-to-equity level. Currently the debt-to-equity ratio stands at a reasonable 80.92%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? MTO exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of MTO 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%.