The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
NetSol Technologies Inc’s (NASDAQ:NTWK) most recent return on equity was a substandard 4.4% relative to its industry performance of 11.7% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into NTWK’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of NTWK’s returns.
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of NetSol Technologies’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.044 in earnings from this. 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 NetSol Technologies’s equity capital deployed. Its cost of equity is 11.5%. This means NetSol Technologies’s returns actually do not cover its own cost of equity, with a discrepancy of -7.1%. 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 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue NetSol Technologies can generate with its current 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 NetSol Technologies’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 11.9%, which means NetSol Technologies still has headroom to take on more leverage in order to increase profits.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. NetSol Technologies exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of NetSol Technologies’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 NetSol Technologies, there are three fundamental aspects 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 NetSol 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 NetSol Technologies is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of NetSol 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.