This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
The National Security Group Inc (NASDAQ:NSEC) delivered a less impressive 2.2% ROE over the past year, compared to the 8.4% return generated by its industry. NSEC’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 NSEC’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of NSEC’s returns.
Breaking down Return on Equity
Return on Equity (ROE) weighs National Security Group’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.022 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 National Security Group’s equity capital deployed. Its cost of equity is 10.4%. Given a discrepancy of -8.1% between return and cost, this indicated that National Security Group 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
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 Security 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 Security Group’s debt-to-equity level. At 33.4%, National Security Group’s debt-to-equity ratio appears low and indicates that National Security Group still has room to increase leverage and grow its profits.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. National Security Group 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 National Security 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 Security Group, I’ve compiled three pertinent factors 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 Security 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 Security Group is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of National Security 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.