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Will SigmaTron International Inc (SGMA) Continue To Underperform Its Industry?

Sam Bishop

SigmaTron International Inc (NASDAQ:SGMA) generated a below-average return on equity of 2.65% in the past 12 months, while its industry returned 10.88%. Though SGMA'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 SGMA's below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of SGMA's returns. See our latest analysis for SGMA

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs SGMA’s profit against the level of its shareholders’ equity. For example, if SGMA 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 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 SGMA, which is 10.06%. This means SGMA’s returns actually do not cover its own cost of equity, with a discrepancy of -7.41%. 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:

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

NasdaqCM:SGMA Last Perf Oct 5th 17
NasdaqCM:SGMA Last Perf Oct 5th 17

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient SGMA is with its cost management. The other component, asset turnover, illustrates how much revenue SGMA can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check SGMA’s historic debt-to-equity ratio. At 56.43%, SGMA’s debt-to-equity ratio appears sensible and indicates its ROE is generated from its capacity to increase profit without a large debt burden.

NasdaqCM:SGMA Historical Debt Oct 5th 17
NasdaqCM:SGMA Historical Debt Oct 5th 17

What this means for you:

Are you a shareholder? SGMA’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as SGMA still has capacity to improve shareholder returns by borrowing to invest in new projects in the future.

Are you a potential investor? If you are considering investing in SGMA, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on SigmaTron International to help you make a more informed investment decision. If you are not interested in SGMA 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.