Why Independence Group NL (ASX:IGO) Delivered An Inferior ROE Compared To The Industry

Independence Group NL ( ASX:IGO ) generated a below-average return on equity of 1.07% in the past 12 months, while its industry returned 11.12%. IGO'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 IGO's performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of IGO's returns. See our latest analysis for IGO

Breaking down Return on Equity

Return on Equity (ROE) is a measure of IGO's profit relative to its shareholders' equity. For example, if IGO invests $1 in the form of equity, it will generate $0.01 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is measured against cost of equity in order to determine the efficiency of IGO's equity capital deployed. Its cost of equity is 9.72%. This means IGO's returns actually do not cover its own cost of equity, with a discrepancy of -8.65%. 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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient IGO is with its cost management. The other component, asset turnover, illustrates how much revenue IGO can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable IGO's capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt IGO currently has. Currently the debt-to-equity ratio stands at a low 11.37%, which means IGO still has headroom to take on more leverage in order to increase profits.

What this means for you:

Are you a shareholder?IGO exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn't give up as IGO 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% .