This analysis is intended to introduce important early concepts to people who are starting to invest and want a simplistic look at the return on First Capital Inc (NASDAQ:FCAP) stock.
First Capital Inc (NASDAQ:FCAP) outperformed the Thrifts and Mortgage Finance industry on the basis of its ROE – producing a higher 10.11% relative to the peer average of 5.71% over the past 12 months. Superficially, this looks great since we know that FCAP has generated big profits with little equity capital; however, ROE doesn’t tell us how much FCAP has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable FCAP’s ROE is. Check out our latest analysis for First Capital
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of First Capital’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.10 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
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 First Capital, which is 9.58%. This means First Capital returns enough to cover its own cost of equity, with a buffer of 0.53%. This sustainable practice implies that the company 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue First Capital can make from its 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 First Capital currently has. Currently, First Capital 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.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. First Capital’s ROE is impressive relative to the industry average and also covers its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For First Capital, I’ve compiled three important aspects 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.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for First Capital’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of First Capital? 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 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.