I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
K92 Mining Inc (CVE:KNT) delivered a less impressive 5.5% ROE over the past year, compared to the 11.6% return generated by its industry. Though KNT’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 KNT’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of KNT’s returns.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs K92 Mining’s profit against the level of its shareholders’ equity. An ROE of 5.5% implies CA$0.055 returned on every CA$1 invested. 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. K92 Mining’s cost of equity is 16.2%. Since K92 Mining’s return does not cover its cost, with a difference of -10.7%, this means its current use of equity is not efficient and not sustainable. Very simply, K92 Mining 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue K92 Mining can make from its 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 financial leverage can artificially inflate ROE, we need to look at how much debt K92 Mining currently has. At 18.2%, K92 Mining’s debt-to-equity ratio appears low and indicates that K92 Mining still has room to increase leverage and grow its profits.
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. K92 Mining’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.
For K92 Mining, I’ve compiled three key factors you should further research:
- 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.
- Valuation: What is K92 Mining 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 K92 Mining is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of K92 Mining? 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 firstname.lastname@example.org.