US Ecology Inc (NASDAQ:ECOL) outperformed the Environmental and Facilities Services industry on the basis of its ROE – producing a higher 15.23% relative to the peer average of 12.04% over the past 12 months. On the surface, this looks fantastic since we know that ECOL has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable ECOL’s ROE is. Check out our latest analysis for US Ecology
Breaking down Return on Equity
Return on Equity (ROE) is a measure of US Ecology’s profit relative to its shareholders’ equity. An ROE of 15.23% implies $0.15 returned on every $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
Returns are usually compared to costs to measure the efficiency of capital. US Ecology’s cost of equity is 8.49%. This means US Ecology returns enough to cover its own cost of equity, with a buffer of 6.74%. This sustainable practice implies that the company 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from US Ecology’s 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 artificially increased through excessive borrowing, we should check US Ecology’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 85.67%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. US Ecology exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.