Rectifier Technologies Limited (ASX:RFT) generated a below-average return on equity of 9.02% in the past 12 months, while its industry returned 9.19%. RFT’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 RFT’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of RFT’s returns. See our latest analysis for Rectifier Technologies
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Rectifier Technologies’s profit relative to its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.09 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 Rectifier Technologies, which is 10.88%. Given a discrepancy of -1.86% between return and cost, this indicated that Rectifier Technologies may be paying more for its capital than what it’s generating in return. 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 Rectifier Technologies can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Rectifier Technologies’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 33.87%, which means Rectifier Technologies still has headroom to take on more leverage in order to increase profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Rectifier Technologies’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.