How Did Aristocrat Leisure Limited’s (ASX:ALL) 40.10% ROE Fare Against The Industry?
Aristocrat Leisure Limited (ASX:ALL) delivered an ROE of 40.10% over the past 12 months, which is an impressive feat relative to its industry average of 11.89% during the same period. Superficially, this looks great since we know that ALL has generated big profits with little equity capital; however, ROE doesn’t tell us how much ALL has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of ALL’s ROE. Check out our latest analysis for Aristocrat Leisure
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 ALL invests $1 in the form of equity, it will generate $0.4 in earnings from this. 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 ALL, which is 8.55%. This means ALL returns enough to cover its own cost of equity, with a buffer of 31.55%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be dissected into three distinct 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
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 ALL 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 ALL’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt ALL currently has. Currently the debt-to-equity ratio stands at a balanced 98.89%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? ALL’s above-industry ROE is encouraging, and is also in excess of 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 ALL 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 Aristocrat Leisure 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.
