Praxair Inc (NYSE:PX) delivered an ROE of 20.06% over the past 12 months, which is an impressive feat relative to its industry average of 13.48% during the same period. However, whether this above-industry ROE is actually impressive depends on if it can be maintained. This can be measured by looking at the company’s financial leverage. With more debt, PX 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. Check out our latest analysis for Praxair
Peeling the layers of ROE – trisecting a company’s profitability
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 the company can generate in earnings given the amount of equity it has raised. If investors diversify their portfolio by industry, they may want to maximise their return in the Industrial Gases sector by investing in the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt Praxair has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Praxair’s equity capital deployed. Its cost of equity is 9.59%. Since Praxair’s return covers its cost in excess of 10.46%, its use of equity capital is efficient and likely to be sustainable. Simply put, Praxair 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Praxair can generate with its current 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. 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 Praxair’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a balanced 137.99%, meaning Praxair has not taken on excessively disproportionate debt to drive its returns. The company is able to produce profit growth without a substantial debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Praxair exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Praxair, I’ve compiled three pertinent aspects you should look at:
- 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 Praxair 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 Praxair is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Praxair? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!