With an ROE of 19.68%, WPP plc (LSE:WPP) outpaced its own industry which delivered a less exciting 9.91% over the past year. On the surface, this looks fantastic since we know that WPP has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of WPP’s ROE. See our latest analysis for WPP
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs WPP’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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. WPP’s cost of equity is 8.30%. This means WPP returns enough to cover its own cost of equity, with a buffer of 11.38%. This sustainable practice implies that the company pays less for its capital than what it generates in return. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from WPP’s 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 WPP currently has. At 76.35%, WPP’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? WPP’s ROE is impressive relative to the industry average and also covers its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of WPP 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%.