Why K12 Inc (NYSE:LRN) May Not Be As Efficient As Its Industry

K12 Inc (NYSE:LRN) delivered a less impressive 1.25% ROE over the past year, compared to the 10.31% return generated by its industry. LRN's results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on LRN’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of LRN's returns. See our latest analysis for K12

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) is a measure of K12’s profit relative to its shareholders’ equity. An ROE of 1.25% implies $0.01 returned on every $1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Education Services 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.

Returns are usually compared to costs to measure the efficiency of capital. K12’s cost of equity is 9.26%. This means K12’s returns actually do not cover its own cost of equity, with a discrepancy of -8.01%. 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 dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

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 K12’s 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 K12’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 K12’s debt-to-equity ratio. The most recent ratio is 4.66%, which is sensible and indicates K12 has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and K12 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. K12’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of K12’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.

For K12, I've compiled three relevant factors you should look at:

1. 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.
2. Valuation: What is K12 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 K12 is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of K12? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.