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.
Nevada Gold & Casinos Inc’s (NYSEMKT:UWN) most recent return on equity was a substandard 3.9% relative to its industry performance of 14.6% over the past year. Though UWN’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 UWN’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of UWN’s returns.
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Nevada Gold & Casinos’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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. Nevada Gold & Casinos’s cost of equity is 9.8%. Since Nevada Gold & Casinos’s return does not cover its cost, with a difference of -5.9%, this means its current use of equity is not efficient and not sustainable. Very simply, Nevada Gold & Casinos pays more for its capital than what it generates in return. ROE can be dissected into three distinct 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 Nevada Gold & Casinos can make from its 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 ROE can be inflated by excessive debt, we need to examine Nevada Gold & Casinos’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 23.1%, which means Nevada Gold & Casinos still has headroom to take on more leverage in order to increase profits.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Nevada Gold & Casinos’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Nevada Gold & Casinos, there are three fundamental 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 Nevada Gold & Casinos 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 Nevada Gold & Casinos is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Nevada Gold & Casinos? 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.