This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between Inovalon Holdings Inc (NASDAQ:INOV)’s return fundamentals and stock market performance.
Inovalon Holdings Inc’s (NASDAQ:INOV) most recent return on equity was a substandard 2.27% relative to its industry performance of 15.12% over the past year. INOV’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 INOV’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of INOV’s returns. Check out our latest analysis for Inovalon Holdings
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 2.27% implies $0.023 returned on every $1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Health Care Technology industry may want to choose 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 Inovalon Holdings’s equity capital deployed. Its cost of equity is 9.93%. Since Inovalon Holdings’s return does not cover its cost, with a difference of -7.66%, this means its current use of equity is not efficient and not sustainable. Very simply, Inovalon Holdings 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:
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. The other component, asset turnover, illustrates how much revenue Inovalon Holdings can make from its 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 Inovalon Holdings’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 38.30%, which is sensible and indicates Inovalon Holdings has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and Inovalon 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. Inovalon Holdings’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. 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 Inovalon Holdings, I’ve put together three pertinent 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 Inovalon 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 Inovalon Holdings is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Inovalon 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!