Yahoo Finance How Did NIC Inc’s (NASDAQ:EGOV) 29.7% ROE Fare Against 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 learn about Return on Equity using a real-life example.
NIC Inc (NASDAQ:EGOV) delivered an ROE of 29.7% over the past 12 months, which is an impressive feat relative to its industry average of 16.1% during the same period. Superficially, this looks great since we know that EGOV has generated big profits with little equity capital; however, ROE doesn’t tell us how much EGOV has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of EGOV’s ROE.
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Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of NIC’s profit relative to its shareholders’ equity. An ROE of 29.7% implies $0.30 returned on every $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
ROE is measured against cost of equity in order to determine the efficiency of NIC’s equity capital deployed. Its cost of equity is 9.9%. Given a positive discrepancy of 19.8% between return and cost, this indicates that NIC pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue NIC 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 the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt NIC currently has. Currently, NIC has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. NIC exhibits a strong ROE against its peers, as well as sufficient returns to cover 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For NIC, I’ve put together three important factors 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 NIC 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 NIC is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of NIC? 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.
