With an ROE of 12.74%, PennantPark Investment Corporation (NASDAQ:PNNT) outpaced its own industry which delivered a less exciting 11.73% over the past year. On the surface, this looks fantastic since we know that PNNT has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable PNNT’s ROE is. Check out our latest analysis for PennantPark Investment
Breaking down Return on Equity
Return on Equity (ROE) is a measure of PNNT’s profit relative to its shareholders’ equity. An ROE of 12.74% implies $0.13 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 PNNT, which is 13.13%. Since PNNT’s return does not cover its cost, with a difference of -0.40%, this means its current use of equity is not efficient and not sustainable. Very simply, PNNT pays more for its capital than what it generates 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 PNNT’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 PNNT’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine PNNT’s debt-to-equity level. At 84.31%, PNNT’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? PNNT’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means PNNT 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%.