Avnet Inc (NYSE:AVT) generated a below-average return on equity of 5.06% in the past 12 months, while its industry returned 10.55%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into AVT’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of AVT’s returns. See our latest analysis for AVT

What you must know about ROE

Return on Equity (ROE) is a measure of AVT’s profit relative to its shareholders’ equity. It essentially shows how much AVT can generate in earnings given the amount of equity it has raised. 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

ROE is measured against cost of equity in order to determine the efficiency of AVT’s equity capital deployed. Its cost of equity is 11.97%. Given a discrepancy of -6.91% between return and cost, this indicated that AVT 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:

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 reveals how much revenue can be generated from AVT’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check AVT’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 32.24%, which means AVT still has headroom to take on more leverage in order to increase profits.

What this means for you:

Are you a shareholder? AVT exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as AVT still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.