Over the past 12 months, Platinum Investment Management Limited (ASX:PTM) generated an ROE of 56%, implying the company created 56 cents on every dollar of shareholders’ invested capital. While Platinum Investment Management turned out to be more efficient than its industry, which delivered a Return on Equity of 18.29%, there are other factors to consider before we call it superior. View our latest analysis for Platinum Investment Management
Peeling the layers of ROE – trisecting a company’s profitability
ROE is simply the percentage of past year earnings against the book value of shareholders’ equity, which is the sum of retained earnings and capital raised through equity offerings. Generally, an ROE of 20% or more is considered highly attractive for any investment consideration. Although, it’s more of an industry-specific ratio as the constituents share similar risk profile.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE above the cost of equity estimate indicates value creation, which apparently is the only reason shares rally. The cost of equity can be estimated through a popular and Nobel-prize winning method called Capital Asset Pricing Model (CAPM). With a few sets of assumptions, the CAPM pegs PTM’s cost of equity at 10.09%, compared to its ROE of 56%.
When we break down ROE using a very popular method called Dupont Formula, it unfolds into three key ratios which are responsible for a company’s profitability: net profit margin, asset turnover, and financial leverage. While higher margin and asset turnover indicate improved efficiency, investors should be cautious about the impact of increased leverage.
ROE = annual net profit ÷ shareholders’ equity
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = profit margin × asset turnover × financial leverage
A trend of profit growing faster than revenue is indicative of improvement in ROE. While investors should assess the past correlation between them, an assessment of the analysts’ profit and revenue forecast points to the most likely scenario going forward. While the change in a company’s asset turnover ratio is important in assessing the quality of ROE, an equally important aspect is its comparison to the industry average. Platinum Investment Management generated an ROA of 48.2% versus the industry’s 6.91%. For an industry, ROA, which is earnings as a percentage of assets, is a sound representation of asset turnover.
The impact of leverage on ROE is reflected in a company’s debt-equity profile. Rapidly rising debt compared to equity, while profit margin and asset turnover underperform, raises a red flag on the ROE. It’s important as a company can inflate its ROE by consistently increasing debt despite weak operating performance. PTM’s debt to equity ratio currently stands at 0. Investors should be cautious about any sharp change in this ratio, more so if it’s due to increasing debt.
ROE – It’s not just another ratio
While ROE can be calculated through a very simple calculation, investors should look at various ratios by breaking it down and how each of them affects the return to understand the strengths and weakness of a company. It’s one of the few ratios which stitches together performance metrics from the income statement and the balance sheet. What are the analysts’ projection of Platinum Investment Management’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
If you are not interested in PTM anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.