This article is intended for those of you who are at the beginning of your investing journey and want a simplistic look at the return on Servotronics Inc (NYSEMKT:SVT) stock.
Servotronics Inc (NYSEMKT:SVT) delivered a less impressive 5.72% ROE over the past year, compared to the 11.22% return generated by its industry. 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 SVT’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of SVT’s returns. Let me show you what I mean by this. See our latest analysis for Servotronics
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Servotronics’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.057 in earnings from this. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Electrical Components and Equipment sector by choosing 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 Servotronics’s equity capital deployed. Its cost of equity is 10.88%. Since Servotronics’s return does not cover its cost, with a difference of -5.17%, this means its current use of equity is not efficient and not sustainable. Very simply, Servotronics 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:
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 shows how much revenue Servotronics can generate with its current 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 assess whether Servotronics is fuelling ROE by excessively raising debt. Ideally, Servotronics should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The most recent ratio is 12.51%, which is sensible and indicates Servotronics has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and Servotronics still has room to increase leverage and grow future returns.
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. Servotronics 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. Although ROE can be a useful metric, it is only a small part of diligent research.
For Servotronics, I’ve put together 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.
- Future Earnings: How does Servotronics’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 Servotronics? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!