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 begin learning the link between company’s fundamentals and stock market performance.
IQE plc (LON:IQE) generated a below-average return on equity of 3.4% in the past 12 months, while its industry returned 11.6%. Though IQE’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 IQE’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of IQE’s returns. Let me show you what I mean by this.
Breaking down Return on Equity
Return on Equity (ROE) is a measure of IQE’s profit relative to its shareholders’ equity. An ROE of 3.4% implies £0.034 returned on every £1 invested. 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 IQE, which is 8.3%. This means IQE’s returns actually do not cover its own cost of equity, with a discrepancy of -4.9%. This isn’t sustainable as it implies, very simply, that the company pays more 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from IQE’s 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 IQE currently has. Currently, IQE has no debt which means its returns are driven purely by equity capital. This could explain why IQE’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. IQE exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For IQE, I’ve put together three pertinent factors 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 IQE 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 IQE is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of IQE? 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 firstname.lastname@example.org.