Virtus Health Limited ( ASX:VRT ) outperformed the Healthcare Facilities industry on the basis of its ROE – producing a higher 11.41% relative to the peer average of 11.27% over the past 12 months. On the surface, this looks fantastic since we know that VRT has made large profits from little equity capital; however, ROE doesn't tell us if management have borrowed heavily to make this happen. Today, we'll take a closer look at some factors like financial leverage to see how sustainable VRT's ROE is. See our latest analysis for Virtus Health
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Virtus Health's profit relative to its shareholders' equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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
ROE is measured against cost of equity in order to determine the efficiency of Virtus Health's equity capital deployed. Its cost of equity is 8.55%. This means Virtus Health returns enough to cover its own cost of equity, with a buffer of 2.86%. This sustainable practice implies that the company pays less 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 reveals how much revenue can be generated from Virtus Health's asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company's capital structure is. Since ROE can be inflated by excessive debt, we need to examine Virtus Health's debt-to-equity level. At 53.40%, Virtus Health's debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Virtus Health's ROE is impressive relative to the industry average and also covers its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Virtus Health, I've compiled three relevant aspects you should further examine:
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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.
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Valuation: What is Virtus Health 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 Virtus Health is currently mispriced by the market.
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Other High-Growth Alternatives: Are there other high-growth stocks you could be holding instead of Virtus Health? 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 pass 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.
