Did GlaxoSmithKline plc (NYSE:GSK) Create Value For Shareholders?

GlaxoSmithKline plc (NYSE:GSK) delivered an ROE of 62.17% over the past 12 months, which is an impressive feat relative to its industry average of 10.75% during the same period. However, whether this above-industry ROE is actually impressive depends on if it can be maintained. 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 GlaxoSmithKline

Breaking down ROE — the mother of all ratios

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 62.17% implies $0.62 returned on every $1 invested, so the higher the return, the better. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Pharmaceuticals sector by choosing 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. GlaxoSmithKline’s cost of equity is 8.49%. This means GlaxoSmithKline returns enough to cover its own cost of equity, with a buffer of 53.67%. This sustainable practice implies that the company pays less 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:

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 GlaxoSmithKline’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether GlaxoSmithKline is fuelling ROE by excessively raising debt. Ideally, GlaxoSmithKline 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 is significantly high, above 2.5 times, meaning GlaxoSmithKline has taken on a disproportionately large level of debt which is driving the high return. The company’s ability to produce profit growth hinges on its large debt burden.

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. GlaxoSmithKline’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of GlaxoSmithKline’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For GlaxoSmithKline, there are three pertinent factors you should further research below. Just a heads up - to access some parts of the Simply Wall St research tool you might be asked to create a free account, but it takes just one click and the information they provide is definitely worth it in my opinion.

• 1. Financial Health: Does it have a healthy balance sheet? Take a look at this free balance sheet analysis with six simple checks on key factors like leverage and risk.
• 2. Valuation: What is GlaxoSmithKline worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in this free research report helps visualize whether GlaxoSmithKline is currently mispriced by the market.
• 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of GlaxoSmithKline? Explore this interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!