I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
With an ROE of 49.8%, The Sherwin-Williams Company (NYSE:SHW) outpaced its own industry which delivered a less exciting 14.4% over the past year. But what is more interesting is whether SHW can sustain this above-average ratio. 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.
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Sherwin-Williams’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.50 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Specialty Chemicals 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 Sherwin-Williams 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 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 Sherwin-Williams, which is 11.0%. Since Sherwin-Williams’s return covers its cost in excess of 38.8%, its use of equity capital is efficient and likely to be sustainable. Simply put, Sherwin-Williams 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 Sherwin-Williams can generate with its current 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 Sherwin-Williams’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at more than 2.5 times, which is very high. This means Sherwin-Williams’s above-average ROE is being driven by its significant debt levels and its ability to grow profit hinges on a significant debt burden.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Sherwin-Williams’s above-industry ROE is encouraging, and is also in excess of its cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Sherwin-Williams, I’ve compiled three pertinent factors 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 Sherwin-Williams 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 Sherwin-Williams is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Sherwin-Williams? 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.