Credit Acceptance Corporation (NASDAQ:CACC) delivered an ROE of 30.24% over the past 12 months, which is an impressive feat relative to its industry average of 12.31% during the same period. While the impressive ratio tells us that CACC has made significant profits from little equity capital, ROE doesn’t tell us if CACC has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of CACC’s ROE. View our latest analysis for Credit Acceptance

What you must know about ROE

Return on Equity (ROE) is a measure of Credit Acceptance’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.3 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

ROE is measured against cost of equity in order to determine the efficiency of Credit Acceptance’s equity capital deployed. Its cost of equity is 11.94%. This means Credit Acceptance returns enough to cover its own cost of equity, with a buffer of 18.30%. This sustainable practice implies that the company 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 reveals how much revenue can be generated from Credit Acceptance’s 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. Since financial leverage can artificially inflate ROE, we need to look at how much debt Credit Acceptance currently has. The debt-to-equity ratio currently stands at a high 221.99%, meaning the above-average ratio is a result of a large amount of debt.

Next Steps:

While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Credit Acceptance exhibits a strong ROE against its peers, as well as sufficient returns to cover 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 Credit Acceptance’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.

For Credit Acceptance, I’ve compiled three essential factors you should look at:

• 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 Credit Acceptance 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 Credit Acceptance is currently mispriced by the market.

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