With An ROE Of 6.07%, Has Dialight plc’s (LON:DIA) Management Done A Good Job?
Dialight plc (LSE:DIA) generated a below-average return on equity of 6.07% in the past 12 months, while its industry returned 15.83%. DIA’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 DIA’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of DIA’s returns. Let me show you what I mean by this. View our latest analysis for Dialight
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Dialight’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Dialight, which is 12.41%. This means Dialight’s returns actually do not cover its own cost of equity, with a discrepancy of -6.34%. 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 broken down into three different ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
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 the business is with its cost management. Asset turnover shows how much revenue Dialight can generate with its current 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 Dialight’s debt-to-equity level. Currently, Dialight has no debt which means its returns are driven purely by equity capital. This could explain why Dialight’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Dialight’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Dialight’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 Dialight, I’ve compiled three important aspects you should further research:
1. 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.
2. Valuation: What is Dialight 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 Dialight is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Dialight? 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 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.