Lam Research Corporation (NASDAQ:LRCX) delivered 23% ROE over the past year, compared to 23.58% generated by its industry. An investor will typically attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into a company’s past performance. View our latest analysis for Lam Research
Breaking down ROE — the mother of all ratios
ROE is one of the most popular ratios to calculate the profitability of a company. The ratio is arrived by putting net earnings in the numerator and shareholders’ equity in the denominator.While an ROE ratio of more than 15% would draw any investor’s attention, historically, established companies in the developed countries have delivered an ROE between 10% and 12%.
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 LRCX, it stands at 10.31% versus its ROE of 23%. 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 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.Lam Research’s ROA over the past 12 months stood at 9.6% versus the industry’s 10.72%. 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 LRCX is fuelling ROE by excessively raising debt or if it has a balanced capital structure by looking at the historic debt-equity trend of the company. While Lam Research’s debt to equity ratio currently stands at 0.4, investors should assess how it has changed over the past few years. To account for leverage, we should look at LRCX’s Return on capital, which stood at 18% in the past year versus industry’s 4.46%. 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
On the surface, ROE appears to be a simple profitability ratio indicating the return an investor should expect. However, for a sound investment consideration, it should still appear good when a company’s debt profile, profit-revenue trend, and leverage are considered. What do the analysts think about Lam Research’s ROE three-years ahead? I recommend you see our latest FREE analysis report to find out!
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