This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
National Western Life Group Inc (NASDAQ:NWLI) delivered a less impressive 6.5% ROE over the past year, compared to the 9.1% return generated by its industry. NWLI’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 NWLI’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of NWLI’s returns.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs National Western Life Group’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 measured against cost of equity in order to determine the efficiency of National Western Life Group’s equity capital deployed. Its cost of equity is 8.6%. This means National Western Life Group’s returns actually do not cover its own cost of equity, with a discrepancy of -2.1%. 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 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue National Western Life Group 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 ROE can be inflated by excessive debt, we need to examine National Western Life Group’s debt-to-equity level. Currently, National Western Life Group has no debt which means its returns are driven purely by equity capital. This could explain why National Western Life Group’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. National Western Life Group’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of National Western Life Group’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For National Western Life Group, I’ve put together three key aspects 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 National Western Life Group 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 National Western Life Group is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of National Western Life Group? 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.