Platinum Capital Limited (ASX:PMC) delivered an ROE of 12.68% over the past 12 months, which is an impressive feat relative to its industry average of 8.68% during the same period. Superficially, this looks great since we know that PMC has generated big profits with little equity capital; however, ROE doesn’t tell us how much PMC has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable PMC’s ROE is. Check out our latest analysis for Platinum Capital
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Platinum Capital’s profit against the level of its shareholders’ equity. An ROE of 12.68% implies A$0.13 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
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 Platinum Capital, which is 8.55%. Given a positive discrepancy of 4.12% between return and cost, this indicates that Platinum Capital pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be dissected into three distinct 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 Platinum Capital’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 financial leverage can artificially inflate ROE, we need to look at how much debt Platinum Capital currently has. Currently, Platinum Capital 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? PMC 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 PMC 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%.