With an ROE of 18.64%, Oracle Corporation (NYSE:ORCL) outpaced its own industry which delivered a less exciting 13.69% over the past year. On the surface, this looks fantastic since we know that ORCL has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable ORCL’s ROE is. View our latest analysis for Oracle
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of ORCL’s profit relative to its shareholders’ equity. For example, if ORCL invests $1 in the form of equity, it will generate $0.19 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
Returns are usually compared to costs to measure the efficiency of capital. ORCL’s cost of equity is 9.68%. Given a positive discrepancy of 8.96% between return and cost, this indicates that ORCL pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be dissected into three distinct 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient ORCL is with its cost management. The other component, asset turnover, illustrates how much revenue ORCL 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 ORCL’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine ORCL’s debt-to-equity level. The debt-to-equity ratio currently stands at a balanced 94.55%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? ORCL 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 ORCL, 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 Oracle 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.