I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
Coca-Cola Amatil Limited (ASX:CCL) delivered an ROE of 25.2% over the past 12 months, which is an impressive feat relative to its industry average of 10.3% during the same period. While the impressive ratio tells us that CCL has made significant profits from little equity capital, ROE doesn’t tell us if CCL has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable CCL’s ROE is.
What you must know about ROE
Return on Equity (ROE) is a measure of Coca-Cola Amatil’s profit relative to its shareholders’ equity. It essentially shows how much the company 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 measured against cost of equity in order to determine the efficiency of Coca-Cola Amatil’s equity capital deployed. Its cost of equity is 8.6%. Since Coca-Cola Amatil’s return covers its cost in excess of 16.6%, its use of equity capital is efficient and likely to be sustainable. Simply put, Coca-Cola Amatil 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:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Coca-Cola Amatil can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Coca-Cola Amatil’s debt-to-equity level. The debt-to-equity ratio currently stands at a balanced 131%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Coca-Cola Amatil’s ROE is impressive relative to the industry average and also covers its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Coca-Cola Amatil, I’ve put together three fundamental aspects you should look at:
- Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Valuation: What is Coca-Cola Amatil worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Coca-Cola Amatil is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Coca-Cola Amatil? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past 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. For errors that warrant correction please contact the editor at firstname.lastname@example.org.