Xenith IP Group Limited’s (ASX:XIP) most recent return on equity was a substandard 5.37% relative to its industry performance of 16.08% over the past year. 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 XIP's past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of XIP's returns. Check out our latest analysis for Xenith IP Group

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) is a measure of XIP’s profit relative to its shareholders’ equity. An ROE of 5.37% implies $0.05 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 XIP, which is 11.07%. Given a discrepancy of -5.70% between return and cost, this indicated that XIP 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from XIP’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable XIP’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt XIP currently has. Currently the debt-to-equity ratio stands at a low 10.43%, which means XIP still has headroom to take on more leverage in order to increase profits.

What this means for you:

Are you a shareholder? XIP exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as XIP still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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%.

Are you a potential investor? If XIP has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Xenith IP Group to help you make a more informed investment decision.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.