With an ROE of 9.44%, oOh!media Limited (ASX:OML) outpaced its own industry which delivered a less exciting 9.41% over the past year. Superficially, this looks great since we know that OML has generated big profits with little equity capital; however, ROE doesn’t tell us how much OML has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable OML’s ROE is. See our latest analysis for oOh!media
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs oOh!media’s profit against the level of its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.09 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
Returns are usually compared to costs to measure the efficiency of capital. oOh!media’s cost of equity is 14.62%. Since oOh!media’s return does not cover its cost, with a difference of -5.19%, this means its current use of equity is not efficient and not sustainable. Very simply, oOh!media pays more 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 oOh!media can generate with its current 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 oOh!media currently has. The debt-to-equity ratio currently stands at a low 39.60%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. oOh!media’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of industry-beating returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.