This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between company’s fundamentals and stock market performance.
Jernigan Capital Inc (NYSE:JCAP) performed in line with its specialized reits industry on the basis of its ROE – producing a return of 4.8% relative to the peer average of 6.6% over the past 12 months. But what is more interesting is whether JCAP can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of JCAP’s returns.
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. For example, if the company invests $1 in the form of equity, it will generate $0.048 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Specialized REITs sector by investing in 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 Jernigan Capital 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
ROE is measured against cost of equity in order to determine the efficiency of Jernigan Capital’s equity capital deployed. Its cost of equity is 8.6%. Since Jernigan Capital’s return does not cover its cost, with a difference of -3.8%, this means its current use of equity is not efficient and not sustainable. Very simply, Jernigan Capital 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Jernigan Capital can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if Jernigan Capital’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Jernigan Capital’s debt-to-equity ratio. Currently, Jernigan Capital has no debt which means its returns are driven purely by equity capital. This could explain why Jernigan Capital’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Jernigan Capital’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Jernigan Capital’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Jernigan Capital, there are three important factors you should further research:
- 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 Jernigan Capital 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 Jernigan Capital is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Jernigan Capital? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.