The a2 Milk Company Limited (ASX:A2M) delivered an ROE of 38.43% over the past 12 months, which is an impressive feat relative to its industry average of 12.09% during the same period. But what is more interesting is whether A2M can sustain this above-average ratio. A measure of sustainable returns is A2M’s financial leverage. If A2M 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 a2 Milk
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of a2 Milk’s profit relative to its shareholders’ equity. An ROE of 38.43% implies A$0.38 returned on every A$1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Packaged Foods and Meats sector by investing in 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
ROE is measured against cost of equity in order to determine the efficiency of a2 Milk’s equity capital deployed. Its cost of equity is 8.55%. This means a2 Milk returns enough to cover its own cost of equity, with a buffer of 29.88%. This sustainable practice implies that the company 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:
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 the business is with its cost management. Asset turnover reveals how much revenue can be generated from a2 Milk’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at a2 Milk’s debt-to-equity ratio to examine sustainability of its returns. Currently, a2 Milk has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. a2 Milk’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. Although ROE can be a useful metric, it is only a small part of diligent research.
For a2 Milk, there are three essential aspects you should further examine:
- 1. 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.
- 2. Valuation: What is a2 Milk 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 a2 Milk is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of a2 Milk? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!