I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
With an ROE of 40.8%, BWX Technologies Inc (NYSE:BWXT) outpaced its own industry which delivered a less exciting 11.9% over the past year. Superficially, this looks great since we know that BWXT has generated big profits with little equity capital; however, ROE doesn’t tell us how much BWXT has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether BWXT’s ROE is actually sustainable.
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs BWX Technologies’s profit against the level of its shareholders’ equity. An ROE of 40.8% implies $0.41 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 measured against cost of equity in order to determine the efficiency of BWX Technologies’s equity capital deployed. Its cost of equity is 8.8%. This means BWX Technologies returns enough to cover its own cost of equity, with a buffer of 31.9%. This sustainable practice implies that the company 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue BWX 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 BWX Technologies currently has. The debt-to-equity ratio currently stands at a high 175%, meaning the above-average ratio is a result of a large amount of debt.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. BWX Technologies’s above-industry ROE is encouraging, and is also in excess of its cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For BWX Technologies, there are three important factors you should further examine:
- 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 BWX 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 BWX Technologies is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of BWX 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 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.