National Holdings Corporation (NASDAQ:NHLD) generated a below-average return on equity of 8.98% in the past 12 months, while its industry returned 12.81%. NHLD’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on NHLD’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of NHLD’s returns. View our latest analysis for National Holdings
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs NHLD’s profit against the level of its shareholders’ equity. It essentially shows how much NHLD can generate in earnings given the amount of equity it has raised. 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 NHLD, which is 11.77%. Since NHLD’s return does not cover its cost, with a difference of -2.80%, this means its current use of equity is not efficient and not sustainable. Very simply, NHLD pays more 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. Asset turnover shows how much revenue NHLD 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 NHLD’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine NHLD’s debt-to-equity level. Currently, NHLD has no debt which means its returns are driven purely by equity capital. This could explain why NHLD’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
What this means for you:
Are you a shareholder? NHLD’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means NHLD still has room to improve shareholder returns by raising debt to fund new investments. 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 you are considering investing in NHLD, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on National Holdings 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.