Switch Inc (NYSE:SWCH) delivered a less impressive 11.14% ROE over the past year, compared to the 14.62% return generated by its industry. Though SWCH’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 SWCH’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of SWCH’s returns. See our latest analysis for SWCH
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 SWCH invests $1 in the form of equity, it will generate $0.11 in earnings from this. 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
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 SWCH, which is 10.45%. SWCH’s ROE exceeds its cost by 0.69%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than SWCH’s case of positive discrepancy. ROE can be dissected into three distinct 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 SWCH is with its cost management. Asset turnover shows how much revenue SWCH can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check SWCH’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at over 2.5 times, meaning the below-average ratio is already being driven by a large amount of debt.
What this means for you:
Are you a shareholder? While SWCH exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity, which means its generating value for shareholders. However, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more SWCH shares. 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 SWCH, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Switch 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.