Coffee Holding Co Inc (NASDAQ:JVA) generated a below-average return on equity of 3.09% in the past 12 months, while its industry returned 11.32%. Though JVA’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 JVA’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of JVA’s returns. Check out our latest analysis for Coffee Holding
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of JVA’s profit relative to its shareholders’ equity. An ROE of 3.09% implies $0.03 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
Returns are usually compared to costs to measure the efficiency of capital. JVA’s cost of equity is 8.49%. Given a discrepancy of -5.41% between return and cost, this indicated that JVA may be paying more for its capital than what it’s generating 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
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 JVA 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 JVA’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt JVA currently has. Currently the debt-to-equity ratio stands at a low 29.08%, which means JVA still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? JVA’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as JVA still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If JVA has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Coffee Holding to help you make a more informed investment decision.
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.