This analysis is intended to introduce important early concepts to people who are starting to invest and want to better understand how you can grow your money by investing in Genesee & Wyoming Inc (NYSE:GWR).
Genesee & Wyoming Inc (NYSE:GWR) performed in-line with its railroads industry on the basis of its ROE – producing a return of15.43% relative to the peer average of 12.69% over the past 12 months. However, whether this ROE is actually impressive depends on if it can be maintained. This can be measured by looking at the company’s financial leverage. With more debt, GWR can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further. Check out our latest analysis for Genesee & Wyoming
What you must know about ROE
Return on Equity (ROE) weighs Genesee & Wyoming’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.15 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Railroads sector by investing in the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Genesee & Wyoming, which is 9.80%. Since Genesee & Wyoming’s return covers its cost in excess of 5.63%, its use of equity capital is efficient and likely to be sustainable. Simply put, Genesee & Wyoming 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 Genesee & Wyoming can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Genesee & Wyoming is fuelling ROE by excessively raising debt. Ideally, Genesee & Wyoming 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 at a sensible 61.16%, meaning Genesee & Wyoming has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge 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. Genesee & Wyoming’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 Genesee & Wyoming, I’ve compiled three important factors you should look at:
- 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 Genesee & Wyoming 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 Genesee & Wyoming is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Genesee & Wyoming? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!