Schnitzer Steel Industries Inc (NASDAQ:SCHN) outperformed the Steel industry on the basis of its ROE – producing a higher 9.01% relative to the peer average of 5.28% over the past 12 months. Superficially, this looks great since we know that SCHN has generated big profits with little equity capital; however, ROE doesn’t tell us how much SCHN has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether SCHN’s ROE is actually sustainable. View our latest analysis for Schnitzer Steel Industries
Breaking down Return on Equity
Return on Equity (ROE) is a measure of SCHN’s profit relative to its shareholders’ equity. An ROE of 9.01% implies $0.09 returned on every $1 invested. 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 SCHN’s equity capital deployed. Its cost of equity is 10.68%. Since SCHN’s return does not cover its cost, with a difference of -1.68%, this means its current use of equity is not efficient and not sustainable. Very simply, SCHN 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:
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 reveals how much revenue can be generated from SCHN’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable SCHN’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt SCHN currently has. Currently the debt-to-equity ratio stands at a low 35.64%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? SCHN’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means SCHN still has room to improve shareholder returns by raising debt to fund new investments.
Are you a potential investor? If SCHN has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Schnitzer Steel Industries to help you make a more informed investment decision. If you are not interested in SCHN anymore, you can use our free platform to see our list of stocks with Return on Equity over 20%.
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.