The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Rocky Mountain Chocolate Factory Inc (NASDAQ:RMCF) delivered an ROE of 13.3% over the past 12 months, which is an impressive feat relative to its industry average of 13.3% during the same period. Superficially, this looks great since we know that RMCF has generated big profits with little equity capital; however, ROE doesn’t tell us how much RMCF has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable RMCF’s ROE is.
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Rocky Mountain Chocolate Factory’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.13 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. Rocky Mountain Chocolate Factory’s cost of equity is 8.6%. Since Rocky Mountain Chocolate Factory’s return covers its cost in excess of 4.7%, its use of equity capital is efficient and likely to be sustainable. Simply put, Rocky Mountain Chocolate Factory 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Rocky Mountain Chocolate Factory 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 the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Rocky Mountain Chocolate Factory’s historic debt-to-equity ratio. At 10.7%, Rocky Mountain Chocolate Factory’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 one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Rocky Mountain Chocolate Factory exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Rocky Mountain Chocolate Factory, I’ve compiled three important 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 Rocky Mountain Chocolate Factory 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 Rocky Mountain Chocolate Factory is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Rocky Mountain Chocolate Factory? 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 past 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. For errors that warrant correction please contact the editor at email@example.com.