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What is Behind Smith & Nephew plc’s (LON:SN.) Superior ROE?

Smith & Nephew plc (LSE:SN.) delivered an ROE of 21.29% over the past 12 months, which is an impressive feat relative to its industry average of 9.48% during the same period. While the impressive ratio tells us that SN. has made significant profits from little equity capital, ROE doesn’t tell us if SN. has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of SN.’s ROE. View our latest analysis for Smith & Nephew

What you must know about ROE

Return on Equity (ROE) is a measure of Smith & Nephew’s profit relative to its shareholders’ equity. An ROE of 21.29% implies £0.21 returned on every £1 invested. 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 Smith & Nephew, which is 8.30%. Since Smith & Nephew’s return covers its cost in excess of 12.99%, its use of equity capital is efficient and likely to be sustainable. Simply put, Smith & Nephew pays less for its capital than what it generates in return. 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

LSE:SN. Last Perf Dec 22nd 17
LSE:SN. Last Perf Dec 22nd 17

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 shows how much revenue Smith & Nephew can generate with its current 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 financial leverage can artificially inflate ROE, we need to look at how much debt Smith & Nephew currently has. Currently the debt-to-equity ratio stands at a low 39.70%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

LSE:SN. Historical Debt Dec 22nd 17
LSE:SN. Historical Debt Dec 22nd 17

What this means for you:

Are you a shareholder? SN. exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of SN. 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%.

Are you a potential investor? If SN. 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 Smith & Nephew 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.

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