XTEK Limited (ASX:XTE) generated a below-average return on equity of 10.99% in the past 12 months, while its industry returned 14.18%. An investor may 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 XTE’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of XTE’s returns. Check out our latest analysis for XTEK
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs XTEK’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. If investors diversify their portfolio by industry, they may want to maximise their return in the Aerospace and Defense sector by investing in 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 XTEK 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
ROE is measured against cost of equity in order to determine the efficiency of XTEK’s equity capital deployed. Its cost of equity is 10.67%. While XTEK’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for XTEK which is encouraging. ROE can be broken down into three different 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 the business is with its cost management. Asset turnover reveals how much revenue can be generated from XTEK’s asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at XTEK’s debt-to-equity ratio to examine sustainability of its returns. Currently, XTEK has no debt which means its returns are driven purely by equity capital. This could explain why XTEK’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. While XTEK exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of XTEK’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 XTEK, there are three relevant aspects you should look at below. Just a heads up – to access some parts of the Simply Wall St research tool you might be asked to create a free account, but it takes just one click and the information they provide is definitely worth it in my opinion.
- 1. Financial Health: Does it have a healthy balance sheet? Take a look at this free balance sheet analysis with six simple checks on key factors like leverage and risk.
- 2. Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for XTEK’s future outlook? Check out this management and board analysis with insights on CEO compensation and governance factors.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of XTEK? Explore this interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!