In This Article:
I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Limoneira Company’s (NASDAQ:LMNR) most recent return on equity was a substandard 8.8% relative to its industry performance of 14.2% over the past year. LMNR’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 LMNR’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of LMNR’s returns.
View our latest analysis for Limoneira
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.087 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing 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 Limoneira, which is 8.6%. Limoneira’s ROE exceeds its cost by 0.2%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than Limoneira’s case of positive discrepancy. ROE can be split up into three useful 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Limoneira can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Limoneira’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 31.1%, which means Limoneira still has headroom to take on more leverage in order to increase profits.