Alkane Resources Limited (ASX:ALK) generated a below-average return on equity of 6.84% in the past 12 months, while its industry returned 11.89%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into ALK’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of ALK’s returns. See our latest analysis for Alkane Resources
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Alkane Resources’s profit relative to its shareholders’ equity. An ROE of 6.84% implies A$0.07 returned on every A$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 Alkane Resources, which is 9.59%. Since Alkane Resources’s return does not cover its cost, with a difference of -2.75%, this means its current use of equity is not efficient and not sustainable. Very simply, Alkane Resources 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 the business is with its cost management. Asset turnover shows how much revenue Alkane Resources can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Alkane Resources’s historic debt-to-equity ratio. Currently, Alkane Resources has no debt which means its returns are driven purely by equity capital. This could explain why Alkane Resources’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.