Will Clean Seas Seafood Limited (ASX:CSS) Continue To Underperform Its Industry?

Clean Seas Seafood Limited (ASX:CSS) delivered a less impressive 0.39% ROE over the past year, compared to the 11.82% return generated by its industry. Though CSS'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 CSS's below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of CSS's returns. Let me show you what I mean by this. See our latest analysis for Clean Seas Seafood

Breaking down Return on Equity

Return on Equity (ROE) is a measure of Clean Seas Seafood’s profit relative to its shareholders’ equity. An ROE of 0.39% implies A$0 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 Packaged Foods and Meats 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 Clean Seas Seafood has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.

ROE is measured against cost of equity in order to determine the efficiency of Clean Seas Seafood’s equity capital deployed. Its cost of equity is 8.55%. Given a discrepancy of -8.16% between return and cost, this indicated that Clean Seas Seafood may be paying more for its capital than what it’s generating in return. ROE can be dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Clean Seas Seafood can make from its 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. We can assess whether Clean Seas Seafood is fuelling ROE by excessively raising debt. Ideally, Clean Seas Seafood 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 2.25%, which is very low. This means Clean Seas Seafood has not taken on leverage, which could explain its below-average ROE. Clean Seas Seafood still has headroom to take on more leverage in order to grow its returns.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Clean Seas Seafood exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.

For Clean Seas Seafood, there are three relevant aspects you should look at:

• 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. Future Earnings: How does Clean Seas Seafood's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
• 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Clean Seas Seafood? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!