ISRA Vision Parsytec AG (MUN:PAQ3) delivered a less impressive 0.40% ROE over the past year, compared to the 12.51% return generated by its industry. PAQ3’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 PAQ3’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of PAQ3’s returns. View our latest analysis for ISRA Vision Parsytec
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs ISRA Vision Parsytec’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Application Software sector by choosing 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. ISRA Vision Parsytec’s cost of equity is 9.28%. Since ISRA Vision Parsytec’s return does not cover its cost, with a difference of -8.88%, this means its current use of equity is not efficient and not sustainable. Very simply, ISRA Vision Parsytec pays more for its capital than what it generates in return. ROE can be dissected into three distinct 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 reveals how much revenue can be generated from ISRA Vision Parsytec’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. 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 ISRA Vision Parsytec’s debt-to-equity ratio to examine sustainability of its returns. Currently, ISRA Vision Parsytec has no debt which means its returns are driven purely by equity capital. This could explain why ISRA Vision Parsytec’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. ISRA Vision Parsytec’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 ISRA Vision Parsytec’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For ISRA Vision Parsytec, I’ve compiled three pertinent factors 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 ISRA Vision Parsytec’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 ISRA Vision Parsytec? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!