Park Electrochemical Corp (NYSE:PKE) delivered a less impressive 4.24% ROE over the past year, compared to the 10.88% return generated by its industry. Though PKE'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 PKE's below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of PKE's returns. Let me show you what I mean by this. See our latest analysis for PKE

What you must know about ROE

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if PKE invests $1 in the form of equity, it will generate $0.04 in earnings from this. 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 measured against cost of equity in order to determine the efficiency of PKE’s equity capital deployed. Its cost of equity is 10.05%. Given a discrepancy of -5.80% between return and cost, this indicated that PKE may be paying more for its capital than what it’s generating in return. ROE can be dissected into three distinct 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 PKE’s 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 PKE’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine PKE’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 39.09%, meaning PKE still has headroom to borrow debt to increase profits.

What this means for you:

Are you a shareholder? PKE’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 PKE still has capacity to improve shareholder returns by borrowing to invest in new projects in the future.

Are you a potential investor? If PKE has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Park Electrochemical to help you make a more informed investment decision. If you are not interested in PKE 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.