Sociedad Química y Minera de Chile SA (NYSE:SQM) outperformed the fertilizers and agricultural chemicals industry on the basis of its ROE – producing a higher 17.37% relative to the peer average of 13.90% over the past 12 months. But what is more interesting is whether SQM can sustain this above-average ratio. A measure of sustainable returns is SQM’s financial leverage. If SQM 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 Sociedad Química y Minera de Chile
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Sociedad Química y Minera de Chile’s profit relative to its 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 Fertilizers and Agricultural Chemicals sector by investing in 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 Sociedad Química y Minera de Chile, which is 8.69%. Given a positive discrepancy of 8.67% between return and cost, this indicates that Sociedad Química y Minera de Chile 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
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 Sociedad Química y Minera de Chile’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 Sociedad Química y Minera de Chile’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a sensible 51.29%, meaning Sociedad Química y Minera de Chile has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Sociedad Química y Minera de Chile 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. Although ROE can be a useful metric, it is only a small part of diligent research.
For Sociedad Química y Minera de Chile, there are 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 Sociedad Química y Minera de Chile 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 Sociedad Química y Minera de Chile is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Sociedad Química y Minera de Chile? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!