Quaker Chemical Corporation’s (NYSE:KWR) most recent return on equity was a substandard 11.46% relative to its industry performance of 14.58% over the past year. Though KWR’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 KWR’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of KWR’s returns. See our latest analysis for KWR
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs KWR’s profit against the level of its shareholders’ equity. An ROE of 11.46% implies $0.11 returned on every $1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing 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 KWR, which is 10.32%. Some of KWR’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for KWR which is reassuring. 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
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 KWR’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable KWR’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt KWR currently has. At 16.16%, KWR’s debt-to-equity ratio appears low and indicates that KWR still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? Even though KWR returned below the industry average, its ROE comes in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of KWR to your portfolio if your personal research is confirming what the ROE is telling you. 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 you are considering investing in KWR, 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 Quaker Chemical 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.