ChemoCentryx Inc (NASDAQ:CCXI) outperformed the biotechnology industry on the basis of its ROE – producing a higher 56.55% relative to the peer average of 18.07% over the past 12 months. But what is more interesting is whether CCXI can sustain this above-average ratio. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this. Check out our latest analysis for ChemoCentryx
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of ChemoCentryx’s profit relative to its shareholders’ equity. An ROE of 56.55% implies $0.57 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 Biotechnology 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.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of ChemoCentryx’s equity capital deployed. Its cost of equity is 10.60%. Since ChemoCentryx’s return covers its cost in excess of 45.95%, its use of equity capital is efficient and likely to be sustainable. Simply put, ChemoCentryx pays less 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:
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 ChemoCentryx can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether ChemoCentryx is fuelling ROE by excessively raising debt. Ideally, ChemoCentryx should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands at a sensible 18.41%, meaning ChemoCentryx has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. ChemoCentryx exhibits a strong ROE against its peers, as well as sufficient returns to cover 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 ChemoCentryx, I’ve put together three key factors you should look at:
- 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 ChemoCentryx’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 ChemoCentryx? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!