IKONICS Corporation (NASDAQ:IKNX) generated a below-average return on equity of 0.17% in the past 12 months, while its industry returned 13.89%. Though IKNX’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 IKNX’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of IKNX’s returns. See our latest analysis for IKONICS
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of IKONICS’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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. IKONICS’s cost of equity is 9.43%. This means IKONICS’s returns actually do not cover its own cost of equity, with a discrepancy of -9.26%. This isn’t sustainable as it implies, very simply, that the company 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
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 IKONICS can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check IKONICS’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 22.70%, meaning IKONICS still has headroom to borrow debt to increase profits.
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. IKONICS exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of IKONICS’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For IKONICS, there are 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 IKONICS’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 IKONICS? 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.