Can Summit Therapeutics plc (LON:SUMM) Continue To Outperform Its Industry?
This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Summit Therapeutics plc (LON:SUMM) outperformed the Biotechnology industry on the basis of its ROE – producing a higher 65.7% relative to the peer average of 22.3% over the past 12 months. On the surface, this looks fantastic since we know that SUMM has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether SUMM’s ROE is actually sustainable.
View our latest analysis for Summit Therapeutics
What you must know about ROE
Return on Equity (ROE) weighs Summit Therapeutics’s profit against the level of its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.66 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
Returns are usually compared to costs to measure the efficiency of capital. Summit Therapeutics’s cost of equity is 8.3%. This means Summit Therapeutics returns enough to cover its own cost of equity, with a buffer of 57.4%. This sustainable practice implies that the company pays less 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:
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 Summit Therapeutics 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 Summit Therapeutics’s debt-to-equity level. Currently, Summit Therapeutics has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Summit Therapeutics exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Summit Therapeutics, I’ve put together three pertinent factors you should look at:
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.
Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for Summit Therapeutics’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Summit Therapeutics? 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 editorial-team@simplywallst.com.
