This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Phoenix New Media Limited (NYSE:FENG) generated a below-average return on equity of 0.37% in the past 12 months, while its industry returned 12.91%. FENG’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on FENG’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of FENG’s returns. Let me show you what I mean by this.
What you must know about ROE
Return on Equity (ROE) weighs Phoenix New Media’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.0037 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Internet Software and Services 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
Returns are usually compared to costs to measure the efficiency of capital. Phoenix New Media’s cost of equity is 12.61%. This means Phoenix New Media’s returns actually do not cover its own cost of equity, with a discrepancy of -12.24%. This isn’t sustainable as it implies, very simply, that the company 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
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 Phoenix New Media’s asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. We can determine if Phoenix New Media’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 Phoenix New Media’s debt-to-equity ratio. Currently the ratio stands at 12.07%, which is very low. This means Phoenix New Media has not taken on leverage, which could explain its below-average ROE. Phoenix New Media still has headroom to take on more leverage in order to grow its returns.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Phoenix New Media’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.
For Phoenix New Media, I’ve compiled three pertinent 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 Phoenix New Media 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 Phoenix New Media is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Phoenix New Media? 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 firstname.lastname@example.org.