The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to better understand how you can grow your money by investing in American Railcar Industries Inc (NASDAQ:ARII).
With an ROE of 21.61%, American Railcar Industries Inc (NASDAQ:ARII) outpaced its own industry which delivered a less exciting 11.36% over the past year. Though, the impressiveness of ARII’s ROE is contingent on whether this industry-beating level can be sustained. A measure of sustainable returns is ARII’s financial leverage. If ARII borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface. See our latest analysis for American Railcar Industries
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. If investors diversify their portfolio by industry, they may want to maximise their return in the Construction Machinery and Heavy Trucks 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 American Railcar Industries’s equity capital deployed. Its cost of equity is 12.45%. Since American Railcar Industries’s return covers its cost in excess of 9.16%, its use of equity capital is efficient and likely to be sustainable. Simply put, American Railcar Industries 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
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 American Railcar Industries’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if American Railcar Industries’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 American Railcar Industries’s debt-to-equity ratio. The most recent ratio is 80.60%, which is sensible and indicates American Railcar Industries has not taken on too much leverage. Thus, we can conclude its above-average ROE is generated from its capacity to increase profit without a large debt burden.
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. American Railcar Industries’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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For American Railcar Industries, I’ve put together three essential factors you should further research:
- 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 American Railcar Industries 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 American Railcar Industries is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of American Railcar Industries? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!