This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.
Axalta Coating Systems Ltd (NYSE:AXTA) delivered a less impressive 10.6% ROE over the past year, compared to the 14.2% return generated by its industry. AXTA’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 AXTA’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of AXTA’s returns. Let me show you what I mean by this.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Axalta Coating Systems’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.11 in earnings from this. 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
ROE is measured against cost of equity in order to determine the efficiency of Axalta Coating Systems’s equity capital deployed. Its cost of equity is 12.7%. This means Axalta Coating Systems’s returns actually do not cover its own cost of equity, with a discrepancy of -2.1%. 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 split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the 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 Axalta Coating Systems 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 Axalta Coating Systems’s debt-to-equity level. The debt-to-equity ratio currently stands at over 2.5 times, meaning the below-average ratio is already being driven by a large amount of debt.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Axalta Coating Systems exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Its concerning leverage level means its ROE is already supported by high debt, raising questions over whether ROE will further decline in the future. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Axalta Coating Systems, I’ve put together three important 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 Axalta Coating Systems 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 Axalta Coating Systems is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Axalta Coating Systems? 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 firstname.lastname@example.org.