This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Mesabi Trust (NYSE:MSB) outperformed the Steel industry on the basis of its ROE – producing a higher 149% relative to the peer average of 10.2% over the past 12 months. On the surface, this looks fantastic since we know that MSB 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 MSB’s ROE.
What you must know about ROE
Return on Equity (ROE) is a measure of Mesabi Trust’s profit relative to its shareholders’ equity. An ROE of 149% implies $1.49 returned on every $1 invested. 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 Mesabi Trust, which is 9.6%. This means Mesabi Trust returns enough to cover its own cost of equity, with a buffer of 139%. This sustainable practice implies that the company pays less for its capital than what it generates in return. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Mesabi Trust’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 financial leverage can artificially inflate ROE, we need to look at how much debt Mesabi Trust currently has. Currently, Mesabi Trust 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.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Mesabi Trust’s ROE is impressive relative to the industry average and also covers 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. Although ROE can be a useful metric, it is only a small part of diligent research.
For Mesabi Trust, I’ve compiled three relevant 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 Mesabi Trust 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 Mesabi Trust is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Mesabi Trust? 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.