Deltic Timber Corporation’s (NYSE:DEL) most recent return on equity was a substandard 3.41% relative to its industry performance of 6.44% over the past year. Though DEL'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 DEL's below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of DEL's returns. View our latest analysis for Deltic Timber
What you must know about ROE
Return on Equity (ROE) weighs DEL’s profit against the level of its shareholders’ equity. For example, if DEL invests $1 in the form of equity, it will generate $0.03 in earnings from this. 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 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 DEL, which is 11.17%. Given a discrepancy of -7.76% between return and cost, this indicated that DEL may be paying more for its capital than what it’s generating 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from DEL’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable DEL’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine DEL’s debt-to-equity level. At 95.51%, DEL’s debt-to-equity ratio appears balanced and indicates its ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? DEL exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means DEL still has room to improve shareholder returns by raising debt to fund new investments.
Are you a potential investor? If DEL 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 Deltic Timber to help you make a more informed investment decision. If you are not interested in DEL anymore, you can use our free platform to see our list of stocks with Return on Equity over 20%.
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.