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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want a simplistic look at the return on Psychemedics Corporation (NASDAQ:PMD) stock.
Psychemedics Corporation (NASDAQ:PMD) outperformed the Healthcare Services industry on the basis of its ROE – producing a higher 30.63% relative to the peer average of 13.80% over the past 12 months. While the impressive ratio tells us that PMD has made significant profits from little equity capital, ROE doesn’t tell us if PMD has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of PMD’s ROE. Check out our latest analysis for Psychemedics
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Psychemedics’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. 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 measured against cost of equity in order to determine the efficiency of Psychemedics’s equity capital deployed. Its cost of equity is 8.59%. Since Psychemedics’s return covers its cost in excess of 22.04%, its use of equity capital is efficient and likely to be sustainable. Simply put, Psychemedics 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Psychemedics can make from its 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 Psychemedics’s historic debt-to-equity ratio. At 16.37%, Psychemedics’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Psychemedics exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.
For Psychemedics, I’ve compiled three important aspects 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 Psychemedics 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 Psychemedics is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Psychemedics? 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.