Castle Brands Inc (AMEX:ROX) delivered a less impressive 1.70% ROE over the past year, compared to the 18.78% return generated by its industry. Though ROX’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 ROX’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of ROX’s returns. Check out our latest analysis for Castle Brands
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if ROX invests $1 in the form of equity, it will generate $0.02 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
Returns are usually compared to costs to measure the efficiency of capital. ROX’s cost of equity is 8.49%. Given a discrepancy of -6.79% between return and cost, this indicated that ROX 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient ROX is with its cost management. The other component, asset turnover, illustrates how much revenue ROX 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 ROX’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt ROX currently has. At over 2.5 times, ROX’s debt-to-equity ratio is very high and indicates the below-average ROE is already being generated by significant leverage levels.
What this means for you:
Are you a shareholder? ROX’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Additionally, with debt capital in excess of equity, the existing ROE is being generated by debt funding, which is something you should be aware of before buying more ROX shares. 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 ROX, 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 Castle Brands 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.