Why Lynas Corporation Limited (ASX:LYC) Delivered An Inferior ROE Compared To The Industry

Lynas Corporation Limited (ASX:LYC) delivered a less impressive 3.30% ROE over the past year, compared to the 11.24% return generated by its industry. 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 LYC's past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of LYC's returns. Check out our latest analysis for Lynas

Breaking down Return on Equity

Return on Equity (ROE) weighs Lynas’s profit against the level of its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.03 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Diversified Metals and Mining 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 Lynas has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.

Returns are usually compared to costs to measure the efficiency of capital. Lynas’s cost of equity is 10.33%. Since Lynas’s return does not cover its cost, with a difference of -7.03%, this means its current use of equity is not efficient and not sustainable. Very simply, Lynas 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:

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Lynas’s 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. 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 Lynas’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 91.48%, which is relatively proportionate and indicates Lynas has not taken on extreme leverage. Thus, we can conclude its current ROE is generated from its capacity to increase profit without a massive debt burden.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Lynas 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For Lynas, I've put together three relevant aspects you should further research:

• 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. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for Lynas's future outlook? Check out our 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 Lynas? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.