Ascott Residence Trust (SGX:A68U) outperformed the Residential REITs industry on the basis of its ROE – producing a higher 7.64% relative to the peer average of 7.02% over the past 12 months. While the impressive ratio tells us that A68U has made significant profits from little equity capital, ROE doesn’t tell us if A68U has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of A68U’s ROE. Check out our latest analysis for Ascott Residence Trust
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Ascott Residence Trust’s profit relative to its shareholders’ equity. An ROE of 7.64% implies SGD0.08 returned on every SGD1 invested. 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Ascott Residence Trust, which is 8.38%. This means Ascott Residence Trust’s returns actually do not cover its own cost of equity, with a discrepancy of -0.74%. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Ascott Residence Trust can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Ascott Residence Trust’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 50.76%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? A68U exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means A68U still has room to improve shareholder returns by raising debt to fund new investments. 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%.