AIMS AMP Capital Industrial REIT (SGX:O5RU) generated a below-average return on equity of 0.13% in the past 12 months, while its industry returned 7.02%. O5RU’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 O5RU’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of O5RU’s returns. View our latest analysis for AIMS AMP Capital Industrial REIT
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if O5RU invests SGD1 in the form of equity, it will generate SGD0 in earnings from this. 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 O5RU’s equity capital deployed. Its cost of equity is 8.38%. This means O5RU’s returns actually do not cover its own cost of equity, with a discrepancy of -8.25%. 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:
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 O5RU 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 O5RU’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check O5RU’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a reasonable 62.85%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? O5RU 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 O5RU 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%.