With an ROE of 16.29%, Macy’s Inc (NYSE:M) outpaced its own industry which delivered a less exciting 12.08% over the past year. On the surface, this looks fantastic since we know that M has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of M’s ROE. See our latest analysis for Macy’s

Breaking down Return on Equity

Return on Equity (ROE) is a measure of Macy’s’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.16 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.

Return on Equity = Net Profit ÷ Shareholders Equity

Returns are usually compared to costs to measure the efficiency of capital. Macy’s’s cost of equity is 9.36%. Since Macy’s’s return covers its cost in excess of 6.93%, its use of equity capital is efficient and likely to be sustainable. Simply put, Macy’s 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:

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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Macy’s 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 Macy’s’s debt-to-equity level. Currently the debt-to-equity ratio stands at a balanced 149.60%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Macy’s’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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For Macy’s, I’ve put together three pertinent aspects you should further research:

• 1. 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.

• 2. Valuation: What is Macy’s 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 Macy’s is currently mispriced by the market.

• 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Macy’s? 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.