West Wits Mining Limited (ASX:WWI) generated a below-average return on equity of 2.44% in the past 12 months, while its industry returned 11.36%. WWI’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 WWI’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of WWI’s returns. Let me show you what I mean by this. See our latest analysis for West Wits Mining
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 2.44% implies A$0.02 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 Gold sector by investing in the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of West Wits Mining’s equity capital deployed. Its cost of equity is 9.41%. Given a discrepancy of -6.97% between return and cost, this indicated that West Wits Mining may be paying more for its capital than what it’s generating 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
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 West Wits Mining’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. We can assess whether West Wits Mining is fuelling ROE by excessively raising debt. Ideally, West Wits Mining should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently, West Wits Mining has no debt which means its returns are driven purely by equity capital. This could explain why West Wits Mining’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. West Wits Mining’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. 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 West Wits Mining, I’ve put together three key 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. Future Earnings: How does West Wits Mining’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 West Wits Mining? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!