Ocean Bio-Chem Inc (NASDAQ:OBCI) generated a 9.7% ROE in the last year, compared to its industry’s 27.62% ROE. But the profitability ratio, often called ‘the mother of all ratios’, reflects a company’s performance both on its income statement and balance sheet. Assessing the factors affecting ROE goes a long way in putting it in the right perspective. Check out our latest analysis for Ocean Bio-Chem
Breaking down Return on Equity
ROE ratio basically calculates the net income as a percentage of total capital committed by shareholders, namely shareholders’ equity.Generally, an ROE of 20% or more is considered highly attractive for any investment consideration. Although, it’s more of an industry-specific ratio as the constituents share similar risk profile.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE above the cost of equity estimate indicates value creation, which apparently is the only reason shares rally. The cost of equity can be estimated through a popular and Nobel-prize winning method called Capital Asset Pricing Model (CAPM). With a few sets of assumptions, the CAPM pegs OBCI’s cost of equity at 8.49%, compared to its ROE of 9.7%.
When we break down ROE using a very popular method called Dupont Formula, it unfolds into three key ratios which are responsible for a company’s profitability: net profit margin, asset turnover, and financial leverage. While higher margin and asset turnover indicate improved efficiency, investors should be cautious about the impact of increased leverage.
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.Ocean Bio-Chem’s ROA over the past 12 months stood at 10.7% versus the industry’s 10.14%. 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.
The last but not the least is the financial leverage. It’s an important ratio as a company can hide its poor operating and asset-use efficiency by increasing leverage. Thus, along with ROE, we should look at the Return on capital, which reflects earnings as a percentage of overall capital employed, including debt. For OBCI, ROC stood at 19% versus the industry’s 17.61%.
Why is ROE called the mother of all ratios
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 Ocean Bio-Chem’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
If you are not interested in OBCI anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.