Ethernity Networks Ltd (LON:ENET): Can It Deliver A Superior ROE To The Industry?

I am writing today to help inform people who are new to the stock market and looking to gauge the potential return on investment in Ethernity Networks Ltd (LON:ENET).

Ethernity Networks Ltd (LON:ENET) generated a below-average return on equity of 0.85% in the past 12 months, while its industry returned 7.76%. ENET'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 ENET’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of ENET's returns. Let me show you what I mean by this. View out our latest analysis for Ethernity Networks

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) is a measure of Ethernity Networks’s profit relative to its shareholders’ equity. An ROE of 0.85% implies £0.0085 returned on every £1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Communications Equipment industry may want to choose 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 measured against cost of equity in order to determine the efficiency of Ethernity Networks’s equity capital deployed. Its cost of equity is 8.28%. Since Ethernity Networks’s return does not cover its cost, with a difference of -7.43%, this means its current use of equity is not efficient and not sustainable. Very simply, Ethernity Networks pays more for its capital than what it generates 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:

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. The other component, asset turnover, illustrates how much revenue Ethernity Networks can make from its 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 Ethernity Networks is fuelling ROE by excessively raising debt. Ideally, Ethernity Networks should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently Ethernity Networks has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why Ethernity Networks's' ROE is lower than its industry peers, most of which may have some degree of debt in its business.

Next Steps:

While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Ethernity Networks’s below-industry ROE is disappointing, furthermore, its returns were not even high 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. Although ROE can be a useful metric, it is only a small part of diligent research.

For Ethernity Networks, I've put together three fundamental aspects 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. Future Earnings: How does Ethernity Networks'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 Ethernity Networks? 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.