The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
With an ROE of 45.4%, PepsiCo Inc (NASDAQ:PEP) outpaced its own industry which delivered a less exciting 11.6% over the past year. But what is more interesting is whether PEP can sustain this above-average ratio. This can be measured by looking at the company’s financial leverage. With more debt, PEP can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further.
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs PepsiCo’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.45 in earnings from this. Investors seeking to maximise their return in the Soft Drinks 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for PepsiCo, which is 9.0%. Given a positive discrepancy of 36.5% between return and cost, this indicates that PepsiCo pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from PepsiCo’s 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. We can determine if PepsiCo’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at PepsiCo’s debt-to-equity ratio. The most recent ratio is greater than 2.5 times which is very high, indicating PepsiCo’s above-average ROE is generated by its significant leverage levels and its ability to grow profit hinges on a substantial debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. PepsiCo exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of PepsiCo’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For PepsiCo, I’ve compiled three key 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 PepsiCo 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 PepsiCo is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of PepsiCo? 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.