With an ROE of 18.44%, ASML Holding NV (NASDAQ:ASML) outpaced its own industry which delivered a less exciting 13.00% over the past year. Though, the impressiveness of ASML’s ROE is contingent on whether this industry-beating level can be sustained. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this. View our latest analysis for ASML Holding N.V
What you must know about ROE
Return on Equity (ROE) is a measure of ASML’s profit relative to its shareholders’ equity. An ROE of 18.44% implies €0.18 returned on every €1 invested, so the higher the return, the better. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Semiconductor Equipment sector by choosing the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. ASML’s cost of equity is 10.28%. Given a positive discrepancy of 8.15% between return and cost, this indicates that ASML pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue ASML 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 ASML’s capital structure is. We can determine if ASML’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 ASML’s debt-to-equity ratio. Currently the ratio stands at 27.54%, which is very low. This means ASML has not taken on leverage, and its above-average ROE is driven by its ability to grow its profit without a huge debt burden.
ROE – It’s not just another ratio
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. ASML’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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