3M (MMM 0.13%) stock has had a wild ride. After years of litigation surrounding its multi-decade production of PFAS — deemed “forever” chemicals that wreak havoc on the health of both exposed humans and ecosystems — shares finally found a bottom last year. Over the past 12 months, 3M’s share price has spiked by more than 50%.
After a large settlement, much of 3M’s business has stabilized, including many gauges of profitability. But the company isn’t completely in the clear yet. In fact, there could be even more PFAS lawsuits to come. That’s a problem given the numbers below.
3M relies on debt to boost shareholder returns
Last quarter, 3M’s return on assets — a metric that tracks how good the company is at making money from its assets — jumped back toward historical levels. The same occurred with 3M’s return on equity — a metric that shows how good it is at generating profits for every dollar of shareholder equity. If you ignore the last few years of abnormal financial results, ROA for 3M has averaged just above 10% in recent years, with ROE hovering just below 30%.
How can returns on equity be 30% while returns on assets are just 10%? This is the dynamic that current investors must understand.
MMM Return on Equity data by YCharts
Companies can boost returns on equity by taking on debt. Greater debt levels, all things equal, will generate higher returns on equity versus lower debt levels. That’s great news for shareholders unless those debt levels become unsustainable, potentially forcing the company into bankruptcy, typically wiping out equity holders.
Since the PFAS legal troubles began, 3M’s debt-to-equity levels have risen substantially. That’s helped ROE rebound despite lower than average ROA levels. But the next few years could see more financial instability for 3M stemming from additional class-action lawsuits, and even legal challenges brought by well-financed state governments like California and New York.
3M is far from going bankrupt, but its recent financial results were partially fueled by high debt levels. That could become an issue if more litigation rolls in.
Ryan Vanzo has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends 3M. The Motley Fool has a disclosure policy.