I am writing today to help inform people who are new to the stock market and want to begin learning the link between Novanta Inc (NASDAQ:NOVT)’s return fundamentals and stock market performance.
With an ROE of 10.94%, Novanta Inc (NASDAQ:NOVT) outpaced its own industry which delivered a less exciting 10.81% over the past year. Superficially, this looks great since we know that NOVT has generated big profits with little equity capital; however, ROE doesn’t tell us how much NOVT has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether NOVT’s ROE is actually sustainable. Check out our latest analysis for Novanta
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Novanta’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.11 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 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 Novanta, which is 9.54%. Since Novanta’s return covers its cost in excess of 1.41%, its use of equity capital is efficient and likely to be sustainable. Simply put, Novanta 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:
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. Asset turnover reveals how much revenue can be generated from Novanta’s 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 ROE can be inflated by excessive debt, we need to examine Novanta’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 62.44%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Novanta 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Novanta, there are three fundamental factors you should further research:
- 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 Novanta 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 Novanta is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Novanta? 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.