LANXESS Aktiengesellschaft (XTRA:LXS) delivered a less impressive 3.63% ROE over the past year, compared to the 12.73% return generated by its industry. LXS’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on LXS’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of LXS’s returns. View our latest analysis for LANXESS
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs LANXESS’s profit against the level of its shareholders’ equity. An ROE of 3.63% implies €0.04 returned on every €1 invested. 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. LANXESS’s cost of equity is 10.74%. This means LANXESS’s returns actually do not cover its own cost of equity, with a discrepancy of -7.10%. 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 broken down into three different 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 LANXESS 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 financial leverage can artificially inflate ROE, we need to look at how much debt LANXESS currently has. Currently the debt-to-equity ratio stands at a reasonable 84.24%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. LANXESS’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of LANXESS’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For LANXESS, there are three relevant factors you should further examine:
- 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.
- Valuation: What is LANXESS worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether LANXESS is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of LANXESS? 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.