With an ROE of 38.36%, Nexus Infrastructure plc (AIM:NEXS) outpaced its own industry which delivered a less exciting 10.04% over the past year. On the surface, this looks fantastic since we know that NEXS has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether NEXS’s ROE is actually sustainable. See our latest analysis for Nexus Infrastructure

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

Return on Equity (ROE) is a measure of Nexus Infrastructure’s profit relative to its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.38 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 Nexus Infrastructure’s equity capital deployed. Its cost of equity is 8.30%. This means Nexus Infrastructure returns enough to cover its own cost of equity, with a buffer of 30.06%. This sustainable practice implies that the company pays less 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 Nexus Infrastructure’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 financial leverage can artificially inflate ROE, we need to look at how much debt Nexus Infrastructure currently has. Currently the debt-to-equity ratio stands at a reasonable 53.01%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

What this means for you:

Are you a shareholder? NEXS’s ROE is impressive relative to the industry average and also covers its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of NEXS 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%.