I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
SMART Global Holdings Inc (NASDAQ:SGH) delivered an ROE of 47.81% over the past 12 months, which is an impressive feat relative to its industry average of 13.89% during the same period. But what is more interesting is whether SGH 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.
Breaking down Return on Equity
Return on Equity (ROE) weighs SMART Global Holdings’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Semiconductors sector by choosing 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 SMART Global Holdings 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 SMART Global Holdings’s equity capital deployed. Its cost of equity is 11.41%. This means SMART Global Holdings returns enough to cover its own cost of equity, with a buffer of 36.40%. This sustainable practice implies that the company 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 reveals how much revenue can be generated from SMART Global Holdings’s 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. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at SMART Global Holdings’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 95.39%, which is relatively proportionate and indicates SMART Global Holdings has not taken on extreme leverage. Thus, we can conclude its above-average ROE is generated from its capacity to increase profit without a massive debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. SMART Global Holdings exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For SMART Global Holdings, there are three fundamental aspects you should further examine:
- 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 SMART Global Holdings 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 SMART Global Holdings is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of SMART Global Holdings? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!