Is Woolworths Limited’s (ASX:WOW) 15.89% ROE Good Enough Compared To Its Industry?
With an ROE of 15.89%, Woolworths Limited (ASX:WOW) outpaced its own industry which delivered a less exciting 11.55% over the past year. While the impressive ratio tells us that WOW has made significant profits from little equity capital, ROE doesn’t tell us if WOW has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of WOW’s ROE. View our latest analysis for Woolworths
What you must know about ROE
Return on Equity (ROE) is a measure of WOW’s profit relative to its shareholders’ equity. For example, if WOW invests $1 in the form of equity, it will generate $0.16 in earnings from this. 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. WOW’s cost of equity is 8.55%. Since WOW’s return covers its cost in excess of 7.33%, its use of equity capital is efficient and likely to be sustainable. Simply put, WOW 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:
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 WOW is with its cost management. The other component, asset turnover, illustrates how much revenue WOW can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable WOW’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt WOW currently has. Currently the debt-to-equity ratio stands at a low 30.69%, 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? WOW 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 WOW 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 Woolworths to help you make a more informed investment decision. If you are not interested in WOW 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.
