Scholastic Corporation’s (NASDAQ:SCHL) most recent return on equity was a substandard 2.30% relative to its industry performance of 11.40% over the past year. Though SCHL’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on SCHL’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of SCHL’s returns. Let me show you what I mean by this. See our latest analysis for Scholastic
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. An ROE of 2.30% implies $0.02 returned on every $1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Scholastic’s equity capital deployed. Its cost of equity is 8.87%. Since Scholastic’s return does not cover its cost, with a difference of -6.57%, this means its current use of equity is not efficient and not sustainable. Very simply, Scholastic 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 Scholastic’s asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Scholastic’s debt-to-equity level. Currently Scholastic has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why Scholastic’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
What this means for you:
Are you a shareholder? SCHL’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as SCHL 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%.