CKX Lands Inc (AMEX:CKX) generated a below-average return on equity of 2.54% in the past 12 months, while its industry returned 7.75%. 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 CKX’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of CKX’s returns. Check out our latest analysis for CKX Lands
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 2.54% implies $0.03 returned on every $1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. CKX’s cost of equity is 9.39%. This means CKX’s returns actually do not cover its own cost of equity, with a discrepancy of -6.85%. 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 dissected into three distinct 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 shows how much revenue CKX 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 CKX’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt CKX currently has. Currently, CKX has no debt which means its returns are driven purely by equity capital. This could explain why CKX’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? CKX’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as CKX 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%.