This article is intended for those of you who are at the beginning of your investing journey
and want to better understand how you can grow your money by investing in Alliance Data Systems Corporation (NYSE:ADS).
With an ROE of 40.28%, Alliance Data Systems Corporation (NYSE:ADS) outpaced its own industry which delivered a less exciting 14.77% over the past year.
However, whether this above-industry ROE is actually impressive depends on if it can be maintained.
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.
Check out our latest analysis for Alliance Data Systems
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Alliance Data Systems’s profit relative to its shareholders’ equity.
For example, if the company invests $1 in the form of equity, it will generate $0.40 in earnings from this.
If investors diversify their portfolio by industry, they may want to maximise their return in the Data Processing and Outsourced Services sector by investing in 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 Alliance Data Systems 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
ROE is measured against cost of equity in order to determine the efficiency of Alliance Data Systems’s equity capital deployed. Its cost of equity is 17.05%.
Since Alliance Data Systems’s return covers its cost in excess of 23.23%, its use of equity capital is efficient and likely to be sustainable. Simply put, Alliance Data Systems pays less for its capital than what it generates in return.
ROE can be dissected into three distinct 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses.
The other component, asset turnover, illustrates how much revenue Alliance Data Systems can make from its asset base.
And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is.
We can determine if Alliance Data Systems’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 Alliance Data Systems’s debt-to-equity ratio.
The ratio currently stands is significantly high, above 2.5 times, meaning Alliance Data Systems has taken on a disproportionately large level of debt which is driving the high return. The company’s ability to produce profit growth hinges on its large debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company.
Alliance Data Systems’s ROE is impressive relative to the industry average and also covers its cost of equity.
Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Alliance Data Systems’s returns.
ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Alliance Data Systems,
- 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 Alliance Data Systems 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 Alliance Data Systems is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Alliance Data Systems? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
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