Imperva Inc (NASDAQ:IMPV) generated a below-average return on equity of 3.60% in the past 12 months, while its industry returned 12.86%. IMPV’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on IMPV’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of IMPV’s returns. Let me show you what I mean by this. View our latest analysis for Imperva
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much IMPV can generate in earnings given the amount of equity it has raised. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Systems Software sector by choosing the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt IMPV has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. IMPV’s cost of equity is 9.63%. This means IMPV’s returns actually do not cover its own cost of equity, with a discrepancy of -6.04%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient IMPV is with its cost management. Asset turnover reveals how much revenue can be generated from IMPV’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable IMPV’s capital structure is. We can determine if IMPV’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at IMPV’s debt-to-equity ratio. Currently, IMPV has no debt which means its returns are driven purely by equity capital. This could explain why IMPV’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE – It’s not just another ratio
ROE is called the mother of all ratios for a reason. It helps gauge a company’s efficiency by looking at both its income statement and balance sheet. IMPV’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of IMPV’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For Imperva, there are three pertinent factors you should further examine:
1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Valuation: What is IMPV worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether IMPV is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of IMPV? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!