Central Securities Corp (AMEX:CET) delivered a 2.4% ROE over the past year; however, the figure is only significant when we compare it to returns from assets with similar risk profile: the industry average, which stood at 12.82% in the same time period. See our latest analysis for CET
What you must know about ROE
ROE is simply the percentage of past year earnings against the book value of shareholders’ equity, which is the sum of retained earnings and capital raised through equity offerings. Any ROE north of 20%, implying 20 cents return on every dollar invested, is favourable for any investor. But investors seek multiple assets to diversify risk and an industry-specific comparison makes more sense to achieve the goal of choosing the best among a given lot.
Return on Equity = Net Profit ÷ Shareholders Equity
For a company to create value for its shareholders, it must generate an ROE higher than the cost of equity. Unlike debt-holders, there is no predefined return for equity investors. However, an expected return to account for market risk can be arrived at using the Capital Asset Pricing Model. For CET, it stands at 10.09% versus its ROE of 2.4%. 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.
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. Central Securities’s ROA over the past 12 months stood at 0.4% versus the industry’s 3.83%. 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.
We can assess whether CET is fuelling ROE by excessively raising debt or it has a balanced capital structure by looking at the historic debt-equity trend of the company. While Central Securities’s debt to equity ratio currently stands at 0, investors should assess how it has changed over the past few years. To account for leverage, we should look at CET’s Return on capital, which stood at 1% in the past year versus industry’s 6.08%. ROC is earnings as a percentage of overall employed capital compared to just equity as in the case of ROE.
ROE – More than just a profitability ratio
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. What are the analysts thinking about Central Securities’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
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