This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Universal Electronics Inc (NASDAQ:UEIC) delivered a less impressive 2.5% ROE over the past year, compared to the 12.6% return generated by its industry. 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 UEIC’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of UEIC’s returns.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Universal Electronics’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.025 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Universal Electronics’s equity capital deployed. Its cost of equity is 9.7%. This means Universal Electronics’s returns actually do not cover its own cost of equity, with a discrepancy of -7.2%. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Universal Electronics can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Universal Electronics currently has. The debt-to-equity ratio currently stands at a sensible 40.0%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Universal Electronics 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 Universal Electronics’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For Universal Electronics, I’ve put together three key 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 Universal Electronics 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 Universal Electronics is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Universal Electronics? 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.