Servotronics Inc’s (AMEX:SVT) most recent return on equity was a substandard 3.41% relative to its industry performance of 12.72% over the past year. Though SVT’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 SVT’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of SVT’s returns. Check out our latest analysis for Servotronics
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of SVT’s profit relative to its shareholders’ equity. For example, if SVT invests $1 in the form of equity, it will generate $0.03 in earnings from this. 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
ROE is measured against cost of equity in order to determine the efficiency of SVT’s equity capital deployed. Its cost of equity is 11.22%. Given a discrepancy of -7.81% between return and cost, this indicated that SVT may be paying more for its capital than what it’s generating 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient SVT is with its cost management. Asset turnover shows how much revenue SVT 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 SVT’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check SVT’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 11.32%, meaning SVT still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? SVT’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as SVT still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If SVT 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 Servotronics to help you make a more informed investment decision.
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.