Nevada Gold & Casinos Inc’s (AMEX:UWN) most recent return on equity was a substandard 2.34% relative to its industry performance of 10.64% over the past year. UWN'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 UWN’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of UWN's returns. See our latest analysis for UWN
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if UWN invests $1 in the form of equity, it will generate $0.02 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
Returns are usually compared to costs to measure the efficiency of capital. UWN’s cost of equity is 11.31%. This means UWN’s returns actually do not cover its own cost of equity, with a discrepancy of -8.97%. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient UWN is with its cost management. Asset turnover shows how much revenue UWN 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 UWN’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt UWN currently has. Currently the debt-to-equity ratio stands at a low 36.72%, which means UWN still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? UWN’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as UWN still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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 you are considering investing in UWN, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Nevada Gold & Casinos 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.