Royal Gold Inc’s (NASDAQ:RGLD) most recent return on equity was a substandard 2.14% relative to its industry performance of 10.44% over the past year. Though RGLD’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 RGLD’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of RGLD’s returns. See our latest analysis for Royal Gold

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) is a measure of Royal Gold’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.02 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 measured against cost of equity in order to determine the efficiency of Royal Gold’s equity capital deployed. Its cost of equity is 10.47%. This means Royal Gold’s returns actually do not cover its own cost of equity, with a discrepancy of -8.33%. 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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Royal Gold’s 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 Royal Gold’s debt-to-equity level. At 21.46%, Royal Gold’s debt-to-equity ratio appears low and indicates that Royal Gold still has room to increase leverage and grow its profits.

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. Royal Gold’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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.