ZAIS Group Holdings Inc’s (NASDAQ:ZAIS) most recent return on equity was a substandard 2.96% relative to its industry performance of 11.19% 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 ZAIS’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of ZAIS’s returns. Check out our latest analysis for ZAIS Group Holdings

What you must know about ROE

Return on Equity (ROE) weighs ZAIS’s profit against the level of its shareholders’ equity. For example, if ZAIS invests $1 in the form of equity, it will generate $0.03 in earnings from this. 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 measured against cost of equity in order to determine the efficiency of ZAIS’s equity capital deployed. Its cost of equity is 17.53%. This means ZAIS’s returns actually do not cover its own cost of equity, with a discrepancy of -14.57%. 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 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 ZAIS’s 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 ZAIS’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at over 2.5 times, meaning the below-average ratio is already being driven by a large amount of debt.

What this means for you:

Are you a shareholder? ZAIS exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Additionally, with debt capital in excess of equity, the existing ROE is being generated by debt funding, which is something you should be aware of before buying more ZAIS shares. 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 you are considering investing in ZAIS, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on ZAIS Group Holdings 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.