Visa Inc (NYSE:V) delivered an ROE of 27.35% over the past 12 months, which is an impressive feat relative to its industry average of 14.62% during the same period. But what is more interesting is whether V 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. View our latest analysis for Visa
Breaking down Return on Equity
Return on Equity (ROE) weighs Visa’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Data Processing and Outsourced Services industry may want to choose 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 Visa 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
Returns are usually compared to costs to measure the efficiency of capital. Visa’s cost of equity is 9.55%. Since Visa’s return covers its cost in excess of 17.80%, its use of equity capital is efficient and likely to be sustainable. Simply put, Visa pays less for its capital than what it generates in return. ROE can be broken down into three different 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 reveals how much revenue can be generated from Visa’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if Visa’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 Visa’s debt-to-equity ratio. The ratio currently stands at a sensible 48.75%, meaning Visa has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge 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. Visa’s ROE is impressive relative to the industry average and also covers 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 Visa, I’ve put together three important factors you should further examine:
- 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 Visa 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 Visa is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Visa? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!