I am writing today to help inform people who are new to the stock market and want a simplistic look at the return on PS&C Limited (ASX:PSZ) stock.
PS&C Limited (ASX:PSZ) generated a below-average return on equity of 0.86% in the past 12 months, while its industry returned 12.33%. Though PSZ’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on PSZ’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of PSZ’s returns. Let me show you what I mean by this. See our latest analysis for PS&C
What you must know about ROE
Return on Equity (ROE) is a measure of PS&C’s profit relative to its shareholders’ equity. An ROE of 0.86% implies A$0.0086 returned on every A$1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Research and Consulting Services industry may want to choose 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 PS&C 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 PS&C’s equity capital deployed. Its cost of equity is 11.30%. This means PS&C’s returns actually do not cover its own cost of equity, with a discrepancy of -10.44%. 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 split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue PS&C can generate with its current 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 PS&C’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 17.26%, which is sensible and indicates PS&C has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and PS&C still has room to increase leverage and grow future returns.
Next Steps:
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. PS&C’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of PS&C’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For PS&C, I’ve put together three essential aspects you should further research:
- 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.
- Valuation: What is PS&C 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 PS&C is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of PS&C? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!