I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
Sachem Capital Corp (NYSEMKT:SACH) delivered an ROE of 10.81% over the past 12 months, which is an impressive feat relative to its industry average of 6.61% during the same period. But what is more interesting is whether SACH can sustain this above-average ratio. This can be measured by looking at the company’s financial leverage. With more debt, SACH can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further.
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Sachem Capital’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.11 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Thrifts and Mortgage Finance 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 Sachem Capital’s equity capital deployed. Its cost of equity is 9.80%. This means Sachem Capital returns enough to cover its own cost of equity, with a buffer of 1.01%. This sustainable practice implies that the company pays less 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Sachem Capital 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 Sachem Capital is fuelling ROE by excessively raising debt. Ideally, Sachem Capital should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently the ratio stands at 29.95%, which is very low. This means Sachem Capital has not taken on leverage, and its above-average ROE is driven by its ability to grow its profit without a huge debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Sachem Capital’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.
For Sachem Capital, I’ve compiled three pertinent factors you should further examine:
- 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.
- Valuation: What is Sachem Capital 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 Sachem Capital is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Sachem Capital? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.