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 Ruth’s Hospitality Group Inc (NASDAQ:RUTH) stock.
With an ROE of 37.44%, Ruth’s Hospitality Group Inc (NASDAQ:RUTH) outpaced its own industry which delivered a less exciting 13.67% over the past year. But what is more interesting is whether RUTH can sustain this above-average ratio. This can be measured by looking at the company’s financial leverage. With more debt, RUTH 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. Check out our latest analysis for Ruth’s Hospitality Group
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Ruth’s Hospitality Group’s profit relative to its shareholders’ equity. An ROE of 37.44% implies $0.37 returned on every $1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Restaurants 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
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 Ruth’s Hospitality Group, which is 9.80%. Given a positive discrepancy of 27.64% between return and cost, this indicates that Ruth’s Hospitality Group pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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. The other component, asset turnover, illustrates how much revenue Ruth’s Hospitality Group 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 determine if Ruth’s Hospitality Group’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 Ruth’s Hospitality Group’s debt-to-equity ratio. The most recent ratio is 49.09%, which is sensible and indicates Ruth’s Hospitality Group 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.
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. Ruth’s Hospitality Group’s above-industry ROE is encouraging, and is also in excess of 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 Ruth’s Hospitality Group, there are three essential 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 Ruth’s Hospitality Group 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 Ruth’s Hospitality Group is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Ruth’s Hospitality Group? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!