Luxfer Holdings PLC’s (NYSE:LXFR) most recent return on equity was a substandard 11.26% relative to its industry performance of 11.66% 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 LXFR’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of LXFR’s returns. See our latest analysis for Luxfer Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Luxfer Holdings’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 measured against cost of equity in order to determine the efficiency of Luxfer Holdings’s equity capital deployed. Its cost of equity is 10.54%. While Luxfer Holdings’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for Luxfer Holdings which is encouraging. 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 Luxfer Holdings can generate with its current 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 Luxfer Holdings currently has. At 69.91%, Luxfer Holdings’s debt-to-equity ratio appears sensible and indicates its ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? Even though LXFR returned below the industry average, its ROE comes in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of LXFR to your portfolio if your personal research is confirming what the ROE is telling you. 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%.