Zenitas Healthcare Limited’s (ASX:ZNT) most recent return on equity was a substandard 0.82% relative to its industry performance of 11.86% over the past year. ZNT's results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on ZNT’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of ZNT's returns. Let me show you what I mean by this. Check out our latest analysis for Zenitas Healthcare
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of ZNT’s profit relative to its shareholders’ equity. An ROE of 0.82% 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
Returns are usually compared to costs to measure the efficiency of capital. ZNT’s cost of equity is 8.55%. This means ZNT’s returns actually do not cover its own cost of equity, with a discrepancy of -7.74%. This isn’t sustainable as it implies, very simply, that the company 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. The other component, asset turnover, illustrates how much revenue ZNT can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt ZNT currently has. The debt-to-equity ratio currently stands at a low 1.02%, meaning ZNT still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? ZNT’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 ZNT 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%.