Lakeland Industries Inc (NASDAQ:LAKE) generated a below-average return on equity of 8.32% in the past 12 months, while its industry returned 12.56%. Though LAKE'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 LAKE's below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of LAKE's returns. View our latest analysis for Lakeland Industries
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs LAKE’s profit against the level of its shareholders’ equity. An ROE of 8.32% implies $0.08 returned on every $1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
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 LAKE, which is 8.49%. This means LAKE’s returns actually do not cover its own cost of equity, with a discrepancy of -0.17%. 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 broken down into three different 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 LAKE is with its cost management. Asset turnover reveals how much revenue can be generated from LAKE’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable LAKE’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check LAKE’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 3.67%, which means LAKE still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? LAKE’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means LAKE still has room to improve shareholder returns by raising debt to fund new investments. 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%.