Clinuvel Pharmaceuticals Limited’s (ASX:CUV) ROE of 17.9% over the past year, compared to its industry’s 44.31%, indicates that investors would have been better off choosing the broader industry in terms of returns generated on their committed capital. However, there is more to a company’s ROE than just the blunt-final-figure. See our latest analysis for CUV
Breaking down Return on Equity
ROE ratio basically calculates the net income as a percentage of total capital committed by shareholders, namely shareholders’ equity.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 CUV, it stands at 13.09% versus its ROE of 17.9%. Using Dupont Analysis, we find out that ROE is composed of three ratios: profit margin, asset turnover, and financial leverage. The method reflects the impact of change in key figures in both the income statement and the balance sheet. The analysis provides a bird’s-eye view on the strengths and weaknesses of the company.
ROE = annual net profit ÷ shareholders’ equity
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = profit margin × asset turnover × financial leverage
A reflection of how net profit margin has affected ROE in the past can be seen in the trend of income and revenue. An investor can gauge a fair estimate of how it’s going to play out in the future by looking at the analysts’ forecasts in the years ahead.The asset turnover for a capital intensive industry such as bricks-and-mortar retail would be substantially lower than the e-commerce retail industry. A comparison with the industry can be drawn through ROA, which represents earnings as a percentage of assets. Clinuvel Pharmaceuticals’s ROA stood at 8.8% in the past year, compared to the industry’s 13.96%.
We can assess whether CUV 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 Clinuvel Pharmaceuticals’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 CUV’s Return on capital, which stood at 13% in the past year versus industry’s -9.42%. 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
While ROE can be calculated through a very simple calculation, investors should look at various ratios by breaking it down and how each of them affects the return to understand the strengths and weakness of a company. It’s one of the few ratios which stitches together performance metrics from the income statement and the balance sheet. What are the analysts’ projection of Clinuvel Pharmaceuticals’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
If you are not interested in CUV anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.