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What is Behind Watsco Inc’s (WSO) Superior ROE?

Watsco Inc (NYSE:WSO) delivered an ROE of 18.53% over the past 12 months, which is an impressive feat relative to its industry average of 9.80% during the same period. Superficially, this looks great since we know that WSO has generated big profits with little equity capital; however, ROE doesn’t tell us how much WSO has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of WSO’s ROE. See our latest analysis for WSO

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. It essentially shows how much WSO 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

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 WSO, which is 9.98%. Since WSO’s return covers its cost in excess of 8.55%, its use of equity capital is efficient and likely to be sustainable. Simply put, WSO 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:

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

NYSE:WSO Last Perf Nov 16th 17
NYSE:WSO Last Perf Nov 16th 17

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue WSO can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check WSO’s historic debt-to-equity ratio. At 21.42%, WSO’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.

NYSE:WSO Historical Debt Nov 16th 17
NYSE:WSO Historical Debt Nov 16th 17

What this means for you:

Are you a shareholder? WSO exhibits a strong ROE against its peers, as well as sufficient returns to cover 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 WSO, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Watsco 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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