With an ROE of 39.42%, Applied Materials Inc (NASDAQ:AMAT) outpaced its own industry which delivered a less exciting 13.00% over the past year. Superficially, this looks great since we know that AMAT has generated big profits with little equity capital; however, ROE doesn’t tell us how much AMAT has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable AMAT’s ROE is. View our latest analysis for Applied Materials
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if AMAT invests $1 in the form of equity, it will generate $0.39 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of AMAT’s equity capital deployed. Its cost of equity is 9.94%. Since AMAT’s return covers its cost in excess of 29.48%, its use of equity capital is efficient and likely to be sustainable. Simply put, AMAT 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:
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 AMAT is with its cost management. The other component, asset turnover, illustrates how much revenue AMAT can make from its 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 AMAT’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt AMAT currently has. At 60.84%, AMAT’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? AMAT’s ROE is impressive relative to the industry average and also covers its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. 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%.
Are you a potential investor? If you are considering investing in AMAT, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Applied Materials to help you make a more informed investment decision.
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.