Yahoo Finance Why IRESS Limited (ASX:IRE) Delivered An Inferior ROE Compared To The Industry
The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
IRESS Limited’s (ASX:IRE) most recent return on equity was a substandard 15.4% relative to its industry performance of 19.8% over the past year. Though IRE’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 IRE’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of IRE’s returns. Let me show you what I mean by this.
View our latest analysis for IRESS
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of IRESS’s profit relative to its shareholders’ equity. An ROE of 15.4% implies A$0.15 returned on every A$1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. IRESS’s cost of equity is 10.0%. IRESS’s ROE exceeds its cost by 5.4%, 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 IRESS’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
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 IRESS 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 IRESS’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 51.3%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Although IRESS’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the cost of equity. Also, 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For IRESS, I’ve compiled three relevant aspects you should look at:
Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
Valuation: What is IRESS worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether IRESS is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of IRESS? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.
