ASV Holdings Inc’s (NASDAQ:ASV) most recent return on equity was a substandard 1.78% relative to its industry performance of 11.58% over the past year. Though ASV’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on ASV’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of ASV’s returns. Check out our latest analysis for ASV Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs ASV Holdings’s profit against the level of its shareholders’ equity. An ROE of 1.78% implies $0.02 returned on every $1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Construction Machinery and Heavy Trucks 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
Returns are usually compared to costs to measure the efficiency of capital. ASV Holdings’s cost of equity is 11.39%. This means ASV Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -9.61%. This isn’t sustainable as it implies, very simply, that the company 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
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 ASV Holdings’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at ASV Holdings’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 42.32%, which is sensible and indicates ASV Holdings has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and ASV Holdings still has room to increase leverage and grow future returns.
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. ASV Holdings exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For ASV Holdings, there are three important 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 ASV Holdings 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 ASV Holdings is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of ASV Holdings? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!