This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between Read-Gene SA (WSE:RDG)’s return fundamentals and stock market performance.
Read-Gene SA (WSE:RDG) generated a below-average return on equity of 1.31% in the past 12 months, while its industry returned 17.03%. 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 RDG’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of RDG’s returns. Check out our latest analysis for Read-Gene
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Read-Gene’s profit relative to 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 Biotechnology 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
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 Read-Gene, which is 10.37%. Since Read-Gene’s return does not cover its cost, with a difference of -9.06%, this means its current use of equity is not efficient and not sustainable. Very simply, Read-Gene 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. Asset turnover reveals how much revenue can be generated from Read-Gene’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 determine if Read-Gene’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Read-Gene’s debt-to-equity ratio. Currently, Read-Gene has no debt which means its returns are driven purely by equity capital. This could explain why Read-Gene’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Read-Gene 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 Read-Gene’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 Read-Gene, I’ve compiled three fundamental factors you should look at:
- 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.
- Future Earnings: How does Read-Gene’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.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Read-Gene? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!