Merrimack Pharmaceuticals Inc (NASDAQ:MACK) delivered an ROE of 175.74% over the past 12 months, which is an impressive feat relative to its industry average of 16.06% during the same period. Though, the impressiveness of MACK’s ROE is contingent on whether this industry-beating level can be sustained. A measure of sustainable returns is MACK’s financial leverage. If MACK borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface. Check out our latest analysis for Merrimack Pharmaceuticals
What you must know about ROE
Return on Equity (ROE) weighs MACK’s profit against the level of its shareholders’ equity. An ROE of 175.74% implies $1.76 returned on every $1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Biotechnology 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
Returns are usually compared to costs to measure the efficiency of capital. MACK’s cost of equity is 12.55%. Since MACK’s return covers its cost in excess of 163.19%, its use of equity capital is efficient and likely to be sustainable. Simply put, MACK 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue MACK can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable MACK’s capital structure is. We can assess whether MACK is fuelling ROE by excessively raising debt. Ideally, MACK 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 44.69%, which is sensible and indicates MACK 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.
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. MACK’s ROE is impressive relative to the industry average and also covers 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 Merrimack Pharmaceuticals, I’ve compiled three important 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. Future Earnings: How does MACK’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.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of MACK? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!