AMCON Distributing Company (AMEX:DIT) delivered a less impressive 4.41% ROE over the past year, compared to the 8.92% return generated by its industry. Though DIT’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on DIT’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of DIT’s returns. Let me show you what I mean by this. Check out our latest analysis for AMCON Distributing
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs AMCON Distributing’s profit against the level of its shareholders’ equity. An ROE of 4.41% implies $0.04 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 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 AMCON Distributing, which is 8.64%. Since AMCON Distributing’s return does not cover its cost, with a difference of -4.23%, this means its current use of equity is not efficient and not sustainable. Very simply, AMCON Distributing pays more 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
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 AMCON Distributing 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 ROE can be inflated by excessive debt, we need to examine AMCON Distributing’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 47.03%, meaning AMCON Distributing still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? DIT exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as DIT still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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 DIT, 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 AMCON Distributing 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.