With an ROE of 12.39%, Net 1 UEPS Technologies Inc (NASDAQ:UEPS) returned in-line to its own industry which delivered 15.00% over the past year. But what is more interesting is whether UEPS can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of UEPS’s returns.
Breaking down Return on Equity
Return on Equity (ROE) is a measure of UEPS’s profit relative to its shareholders’ equity. An ROE of 12.39% implies $0.12 returned on every $1 invested, so the higher the return, the better. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Data Processing and Outsourced Services sector by choosing the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
ROE is measured against cost of equity in order to determine the efficiency of UEPS’s equity capital deployed. Its cost of equity is 10.62%. While UEPS’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for UEPS which is encouraging. ROE can be broken down into three different ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
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 UEPS 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 UEPS’s capital structure is. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at UEPS’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 23.08%, which is sensible and indicates UEPS has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and UEPS still has room to increase leverage and grow future returns.
ROE – It’s not just another ratio
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Even though UEPS returned below the industry average, its ROE comes in excess of its cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of UEPS’s return with a possible increase should the company decide to increase its debt levels. There are other important measures we need to consider in order to conclude on the quality of its returns. I recommend you