With an ROE of 21.29%, Smith & Nephew plc (NYSE:SNN) outpaced its own industry which delivered a less exciting 10.98% over the past year. Though, the impressiveness of SNN’s ROE is contingent on whether this industry-beating level can be sustained. A measure of sustainable returns is SNN’s financial leverage. If SNN borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface. View our latest analysis for Smith & Nephew
Breaking down Return on Equity
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 SNN can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Healthcare Equipment industry may want to choose the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of SNN’s equity capital deployed. Its cost of equity is 8.82%. Since SNN’s return covers its cost in excess of 12.47%, its use of equity capital is efficient and likely to be sustainable. Simply put, SNN pays less for its capital than what it generates in return. ROE can be split up into three useful 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 SNN 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 SNN’s capital structure is. We can assess whether SNN is fuelling ROE by excessively raising debt. Ideally, SNN should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently the ratio stands at 39.70%, which is very low. This means SNN has not taken on leverage, and its above-average ROE is driven by its ability to grow its profit without a huge debt burden.
Why is ROE called the mother of all ratios
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. SNN’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. There are other important measures we need to consider in order to conclude on the quality of its returns. I recommend you see our latest FREE analysis report to find out more about other measures!
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