Cyanotech Corporation’s (NASDAQ:CYAN) most recent return on equity was a substandard 2.01% relative to its industry performance of 18.36% over the past year. Though CYAN’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 CYAN’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of CYAN’s returns. View our latest analysis for Cyanotech
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of CYAN’s profit relative to its shareholders’ equity. For example, if CYAN invests $1 in the form of equity, it will generate $0.02 in earnings from this. 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. CYAN’s cost of equity is 8.49%. Since CYAN’s return does not cover its cost, with a difference of -6.48%, this means its current use of equity is not efficient and not sustainable. Very simply, CYAN 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. The other component, asset turnover, illustrates how much revenue CYAN can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check CYAN’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 39.52%, which means CYAN still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? CYAN’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as CYAN 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 you are considering investing in CYAN, 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 Cyanotech 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.