What is Behind ShotSpotter Inc’s (NASDAQ:SSTI) Superior ROE?
ShotSpotter Inc (NASDAQ:SSTI) outperformed the Internet Software and Services industry on the basis of its ROE – producing a higher 67.65% relative to the peer average of 12.14% over the past 12 months. While the impressive ratio tells us that SSTI has made significant profits from little equity capital, ROE doesn’t tell us if SSTI has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of SSTI’s ROE. View our latest analysis for ShotSpotter
What you must know about ROE
Return on Equity (ROE) weighs ShotSpotter’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.68 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. ShotSpotter’s cost of equity is 9.96%. This means ShotSpotter returns enough to cover its own cost of equity, with a buffer of 57.68%. This sustainable practice implies that the company pays less 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:
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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue ShotSpotter can generate with its current 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. Since ROE can be artificially increased through excessive borrowing, we should check ShotSpotter’s historic debt-to-equity ratio. Currently, ShotSpotter has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
What this means for you:
Are you a shareholder? SSTI’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If SSTI has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on ShotSpotter to help you make a more informed investment decision.
To help readers see pass 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.
