Xenith IP Group Limited (ASX:XIP) generated a below-average return on equity of 3.00% in the past 12 months, while its industry returned 12.33%. XIP’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 XIP’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of XIP’s returns. Check out our latest analysis for Xenith IP Group
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Xenith IP Group’s profit relative to its shareholders’ equity. An ROE of 3.00% implies A$0.03 returned on every A$1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Research and Consulting Services sector by investing in the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Xenith IP Group’s cost of equity is 5.18%. Since Xenith IP Group’s return does not cover its cost, with a difference of -2.19%, this means its current use of equity is not efficient and not sustainable. Very simply, Xenith IP Group pays more for its capital than what it generates in return. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Xenith IP Group can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. We can assess whether Xenith IP Group is fuelling ROE by excessively raising debt. Ideally, Xenith IP Group should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently the ratio stands at 13.30%, which is very low. This means Xenith IP Group has not taken on leverage, which could explain its below-average ROE. Xenith IP Group still has headroom to take on more leverage in order to grow its returns.
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. Xenith IP Group’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 Xenith IP Group’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 Xenith IP Group, I’ve compiled three key factors 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 Xenith IP Group 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 Xenith IP Group is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Xenith IP Group? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!