Did Rio Tinto plc (LSE:RIO) Create Value For Shareholders?
Rio Tinto plc (LSE:RIO) delivered an ROE of 13.61% over the past 12 months, which is an impressive feat relative to its industry average of 9.41% during the same period. While the impressive ratio tells us that RIO has made significant profits from little equity capital, ROE doesn’t tell us if RIO has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of RIO’s ROE. View our latest analysis for Rio Tinto
What you must know about ROE
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 RIO can generate in earnings given the amount of equity it has raised. 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
Returns are usually compared to costs to measure the efficiency of capital. RIO’s cost of equity is 8.95%. Since RIO’s return covers its cost in excess of 4.67%, its use of equity capital is efficient and likely to be sustainable. Simply put, RIO 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 RIO 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 RIO’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine RIO’s debt-to-equity level. At 31.45%, RIO’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.
What this means for you:
Are you a shareholder? RIO 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.
Are you a potential investor? If you are considering investing in RIO, 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 Rio Tinto to help you make a more informed investment decision. If you are not interested in RIO 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.
