With an ROE of 23.01%, Facebook Inc (NASDAQ:FB) outpaced its own industry which delivered a less exciting 12.67% over the past year. But what is more interesting is whether FB 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. See our latest analysis for Facebook
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Facebook’s profit against the level of its shareholders’ equity. An ROE of 23.01% implies $0.23 returned on every $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 Internet Software and Services 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 Facebook, which is 11.87%. This means Facebook returns enough to cover its own cost of equity, with a buffer of 11.14%. This sustainable practice implies that the company 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Facebook 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. We can determine if Facebook’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 Facebook’s debt-to-equity ratio. Currently, Facebook 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. Facebook exhibits a strong ROE against its peers, as well as sufficient returns to cover 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 Facebook, I’ve compiled three relevant 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 Facebook 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 Facebook is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Facebook? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!