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Universal Forest Products Inc (NASDAQ:UFPI) outperformed the Building Products industry on the basis of its ROE – producing a higher 13.37% relative to the peer average of 12.85% over the past 12 months. Superficially, this looks great since we know that UFPI has generated big profits with little equity capital; however, ROE doesn’t tell us how much UFPI has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable UFPI’s ROE is. See our latest analysis for Universal Forest Products
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Universal Forest Products’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 Universal Forest Products, which is 8.96%. This means Universal Forest Products returns enough to cover its own cost of equity, with a buffer of 4.41%. This sustainable practice implies that the company 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
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 Universal Forest Products’s 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 the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Universal Forest Products’s historic debt-to-equity ratio. At 28.69%, Universal Forest Products’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.