Steris Plc’s (NYSE:STE) most recent return on equity was a substandard 4.77% relative to its industry performance of 13.25% over the past year. STE’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 STE’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of STE’s returns. Let me show you what I mean by this. Check out our latest analysis for Steris
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Steris’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Healthcare Equipment industry may want to choose the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt Steris has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Steris’s cost of equity is 8.81%. This means Steris’s returns actually do not cover its own cost of equity, with a discrepancy of -4.04%. 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 broken down into three different 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. Asset turnover shows how much revenue Steris can generate with its current 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 assess whether Steris is fuelling ROE by excessively raising debt. Ideally, Steris 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 47.53%, which is sensible and indicates Steris has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and Steris still has room to increase leverage and grow future returns.
ROE – It’s not just another ratio
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Steris’s ROE is underwhelming relative to the industry average, and its returns were also not strong 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 Steris, I’ve put together three fundamental factors you should further examine:
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 Steris 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 Steris is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Steris? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!