First Derivatives plc’s (AIM:FDP) most recent return on equity was a substandard 6.23% relative to its industry performance of 14.38% over the past year. 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 FDP’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of FDP’s returns. See our latest analysis for First Derivatives
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of First Derivatives’s profit relative to its shareholders’ equity. An ROE of 6.23% implies £0.06 returned on every £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 IT Consulting and Other 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
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for First Derivatives, which is 8.30%. Since First Derivatives’s return does not cover its cost, with a difference of -2.07%, this means its current use of equity is not efficient and not sustainable. Very simply, First Derivatives 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:
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 First Derivatives 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 First Derivatives is fuelling ROE by excessively raising debt. Ideally, First Derivatives should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The most recent ratio is 19.47%, which is sensible and indicates First Derivatives has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and First Derivatives still has room to increase leverage and grow future returns.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. First Derivatives exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of First Derivatives’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 First Derivatives, there are three relevant factors you should further examine:
- 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. Valuation: What is First Derivatives 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 First Derivatives is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of First Derivatives? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!