Is American Express Company’s (AXP) 25.1% ROE Good Enough When Compared To Its Industry?

https://simplywall.st/news/2017/05/30/is-american-express-companys-axp-25-1-roe-good-enough-when-compared-to-its-industry/

While American Express Company’s ( NYSE:AXP ) 25.1% ROE was above the industry average of 12.6%, the role of leverage must also be considered. Leverage can distort an ROE to a great extent. For instance, assuming interest costs are higher than a company’s earnings. The ROE might look impressive, but in reality the shareholders will take a hit instead achieving a positive return.

Peeling the layers of ROE – trisecting a company’s profitability

ROE ratio basically calculates the net income as a percentage of total capital committed by shareholders, namely shareholders’ equity.Generally, an ROE of 20% or more is considered highly attractive for any investment consideration. Although, it’s more of an industry-specific ratio as the constituents share similar risk profile.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE above the cost of equity estimate indicates value creation, which apparently is the only reason shares rally. The cost of equity can be estimated through a popular and Nobel-prize winning method called Capital Asset Pricing Model (CAPM). With a few sets of assumptions, the CAPM pegs AXP’s cost of equity at 11.63%, compared to its ROE of 25.1%.

ROE can be broken down into three ratios using the Dupont formula. The profit margin is the income as a percentage of sales, while asset turnover highlights how efficiently a company is using the resources at its disposal. Increased leverage, primarily through raising debt, is good for a profitable company, but only to the extent it doesn’t make the firm insolvent in a time of crisis.

Dupont Formula

ROE = annual net profit ÷ shareholders’ equity

ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)

ROE = profit margin × asset turnover × financial leverage

A trend of profit growing faster than revenue is indicative of improvement in ROE. While investors should assess the past correlation between them, an assessment of the analysts’ profit and revenue forecast points to the most likely scenario going forward.American Express’s ROA over the past 12 months stood at 3.3% versus the industry’s 2.76%. Although an investor should look at multi-year asset turnover to assess its effect on the latest ROE, a quick comparison with the industry tells him whether it’s acceptable. We use ROA for the comparison as along with sales, used in asset turnover, earnings, used in ROA, are also comparable within the industry.

The impact of leverage on ROE is reflected in a company’s debt-equity profile. Rapidly rising debt compared to equity, while profit margin and asset turnover underperform, raises a red flag on the ROE. It’s important as a company can inflate its ROE by consistently increasing debt despite weak operating performance. AXP’s debt to equity ratio currently stands at 2.65. Investors should be cautious about any sharp change in this ratio, more so if it’s due to increasing debt.

Why is ROE called the mother of all ratios

ROE is called the mother of all ratios for a reason. It helps gauge a company’s efficiency both through the income statement and the balance sheet, along with telling you how just changing the capital structure of the company can impact perceived return.