What You Must Know About The a2 Milk Company Limited’s (NZSE:ATM) ROE
The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to better understand how you can grow your money by investing in The a2 Milk Company Limited (NZSE:ATM).
With an ROE of 38.43%, The a2 Milk Company Limited (NZSE:ATM) outpaced its own industry which delivered a less exciting 14.32% over the past year. While the impressive ratio tells us that ATM has made significant profits from little equity capital, ROE doesn’t tell us if ATM has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable ATM’s ROE is. See our latest analysis for a2 Milk
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of a2 Milk’s profit relative to its shareholders’ equity. An ROE of 38.43% implies NZ$0.38 returned on every NZ$1 invested. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. a2 Milk’s cost of equity is 9.01%. Given a positive discrepancy of 29.42% between return and cost, this indicates that a2 Milk 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:
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 a2 Milk 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. Since ROE can be inflated by excessive debt, we need to examine a2 Milk’s debt-to-equity level. Currently, a2 Milk 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.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. a2 Milk’s above-industry ROE is encouraging, and is also in excess of 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 a2 Milk, I’ve compiled three relevant 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 a2 Milk 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 a2 Milk is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of a2 Milk? 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 pass 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.