Amazoncom Inc. (NASDAQ:AMZN) generated a below-average return on equity of 12.52% in the past 12 months, while its industry returned 16.44%. AMZN’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on AMZN’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of AMZN’s returns. Check out our latest analysis for Amazon.com
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Amazon.com’s profit relative to its shareholders’ equity. An ROE of 12.52% implies $0.13 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 Internet and Direct Marketing Retail sector by choosing 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 Amazon.com 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 Amazon.com, which is 13.27%. Given a discrepancy of -0.76% between return and cost, this indicated that Amazon.com may be paying more for its capital than what it’s generating 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
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 Amazon.com’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if Amazon.com’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 Amazon.com’s debt-to-equity ratio. Currently the ratio stands at 141.40%, which is relatively balanced. This means Amazon.com has not taken on excessive leverage, and its current ROE is driven by its ability to grow its profit without a significant debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Amazon.com’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Amazon.com’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Amazon.com, there are three key aspects you should further research:
- 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 Amazon.com 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 Amazon.com is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Amazon.com? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!