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What is Behind O’Reilly Automotive Inc’s (ORLY) Superior ROE?

Chris Amalia

With an ROE of 83.79%, O'Reilly Automotive Inc (NASDAQ:ORLY) outpaced its own industry which delivered a less exciting 13.12% over the past year. While the impressive ratio tells us that ORLY has made significant profits from little equity capital, ROE doesn’t tell us if ORLY has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of ORLY’s ROE. View our latest analysis for O'Reilly Automotive

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs ORLY’s profit against the level of its shareholders’ equity. An ROE of 83.79% implies $0.84 returned on every $1 invested. 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 ORLY’s equity capital deployed. Its cost of equity is 9.54%. Given a positive discrepancy of 74.25% between return and cost, this indicates that ORLY pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be split up into three useful 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

NasdaqGS:ORLY Last Perf Oct 4th 17

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient ORLY is with its cost management. Asset turnover shows how much revenue ORLY can generate with its current 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 ORLY’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine ORLY’s debt-to-equity level. The debt-to-equity ratio currently stands at over 2.5 times, meaning the above-average ratio is a result of a large amount of debt.

NasdaqGS:ORLY Historical Debt Oct 4th 17

What this means for you:

Are you a shareholder? ORLY’s ROE is impressive relative to the industry average and also covers its cost of equity. However, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more ORLY shares.

Are you a potential investor? If ORLY has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on O'Reilly Automotive to help you make a more informed investment decision. If you are not interested in ORLY anymore, you can use our free platform to see our list of stocks with Return on Equity over 20%.

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.