Should You Expect Gresham Technologies plc (LON:GHT) To Continue Delivering An ROE Of 14.90%?
I am writing today to help inform people who are new to the stock market and looking to gauge the potential return on investment in Gresham Technologies plc (LON:GHT).
Gresham Technologies plc (LON:GHT) outperformed the Application Software industry on the basis of its ROE – producing a higher 14.90% relative to the peer average of 11.51% over the past 12 months. On the surface, this looks fantastic since we know that GHT has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of GHT’s ROE. See our latest analysis for Gresham Technologies
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Gresham Technologies’s profit relative to its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.15 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
ROE is measured against cost of equity in order to determine the efficiency of Gresham Technologies’s equity capital deployed. Its cost of equity is 8.28%. Since Gresham Technologies’s return covers its cost in excess of 6.62%, its use of equity capital is efficient and likely to be sustainable. Simply put, Gresham Technologies pays less 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:
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. The other component, asset turnover, illustrates how much revenue Gresham Technologies 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 financial leverage can artificially inflate ROE, we need to look at how much debt Gresham Technologies currently has. Currently, Gresham Technologies has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Gresham Technologies’s ROE is impressive relative to the industry average and also covers 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Gresham Technologies, there are three key 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.
Valuation: What is Gresham Technologies 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 Gresham Technologies is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Gresham Technologies? 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.
