Why Spectris plc (LSE:SXS) Delivered An Inferior ROE Compared To The Industry
Spectris plc (LSE:SXS) delivered a less impressive 1.07% ROE over the past year, compared to the 14.61% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into SXS's past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of SXS's returns. View our latest analysis for Spectris
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs SXS’s profit against the level of its shareholders’ equity. It essentially shows how much SXS can generate in earnings given the amount of equity it has raised. 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 SXS’s equity capital deployed. Its cost of equity is 8.30%. Given a discrepancy of -7.23% between return and cost, this indicated that SXS may be paying more for its capital than what it’s generating 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
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 SXS’s 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 SXS’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 20.68%, meaning SXS still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? SXS’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 SXS 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 SXS, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Spectris to help you make a more informed investment decision. If you are not interested in SXS 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.
