With an ROE of 21.76%, Adobe Systems Incorporated (NASDAQ:ADBE) outpaced its own industry which delivered a less exciting 13.35% over the past year. Superficially, this looks great since we know that ADBE has generated big profits with little equity capital; however, ROE doesn’t tell us how much ADBE has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether ADBE’s ROE is actually sustainable. View our latest analysis for Adobe Systems
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Adobe Systems’s profit against the level of its shareholders’ equity. An ROE of 21.76% implies $0.22 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. Adobe Systems’s cost of equity is 9.46%. Since Adobe Systems’s return covers its cost in excess of 12.29%, its use of equity capital is efficient and likely to be sustainable. Simply put, Adobe Systems 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:
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. The other component, asset turnover, illustrates how much revenue Adobe Systems can make from its 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 inflated by excessive debt, we need to examine Adobe Systems’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 21.81%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Adobe Systems’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Adobe Systems, there are three relevant aspects you should look at:
- Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Valuation: What is Adobe Systems worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Adobe Systems is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Adobe Systems? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.