This analysis is intended to introduce important early concepts to people who are starting to invest and want to better understand how you can grow your money by investing in Pharmaxis Ltd (ASX:PXS).
With an ROE of 53.94%, Pharmaxis Ltd (ASX:PXS) outpaced its own industry which delivered a less exciting 11.52% over the past year. Superficially, this looks great since we know that PXS has generated big profits with little equity capital; however, ROE doesn’t tell us how much PXS has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether PXS’s ROE is actually sustainable. Check out our latest analysis for Pharmaxis
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Pharmaxis’s profit relative to its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.54 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Pharmaxis’s cost of equity is 10.48%. Since Pharmaxis’s return covers its cost in excess of 43.46%, its use of equity capital is efficient and likely to be sustainable. Simply put, Pharmaxis 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Pharmaxis can make from its 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 the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Pharmaxis currently has. Currently the debt-to-equity ratio stands at a high 165.24%, which means its above-average ROE is driven by significant debt levels.
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. Pharmaxis’s ROE is impressive relative to the industry average and also covers its cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.