BlackPearl Resources Inc’s (TSX:PXX) most recent return on equity was a substandard 2.29% relative to its industry performance of 6.42% over the past year. Though PXX’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on PXX’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of PXX’s returns. See our latest analysis for PXX
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of PXX’s profit relative to its shareholders’ equity. An ROE of 2.29% implies CA$0.02 returned on every CA$1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of PXX’s equity capital deployed. Its cost of equity is 8.49%. Since PXX’s return does not cover its cost, with a difference of -6.20%, this means its current use of equity is not efficient and not sustainable. Very simply, PXX pays more 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. Asset turnover shows how much revenue PXX can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt PXX currently has. At 11.31%, PXX’s debt-to-equity ratio appears low and indicates that PXX still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? PXX’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means PXX still has room to improve shareholder returns by raising debt to fund new investments. 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 PXX 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 BlackPearl Resources 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.