Vertex Pharmaceuticals Incorporated (NASDAQ:VRTX) delivered a less impressive 1.14% ROE over the past year, compared to the 15.86% return generated by its industry. 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 VRTX’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of VRTX’s returns. See our latest analysis for VRTX
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs VRTX’s profit against the level of its shareholders’ equity. An ROE of 1.14% implies $0.01 returned on every $1 invested. 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 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 VRTX, which is 12.78%. Since VRTX’s return does not cover its cost, with a difference of -11.64%, this means its current use of equity is not efficient and not sustainable. Very simply, VRTX 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
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 VRTX can make from its 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 VRTX’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 32.56%, which means VRTX still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? VRTX’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, investors shouldn’t despair since ROE is not inflated by excessive debt, which means VRTX 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%.