Lannett Company Inc’s (NYSE:LCI) most recent return on equity was a substandard 8.09% relative to its industry performance of 10.88% over the past year. Though LCI’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 LCI’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of LCI’s returns. Check out our latest analysis for Lannett Company
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Lannett Company’s profit relative to its shareholders’ equity. An ROE of 8.09% implies $0.08 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 Lannett Company, which is 12.96%. Given a discrepancy of -4.87% between return and cost, this indicated that Lannett Company may be paying more for its capital than what it’s generating 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Lannett Company’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Lannett Company’s debt-to-equity level. The debt-to-equity ratio currently stands at a balanced 149.47%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Lannett Company’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.