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 begin learning the link between company’s fundamentals and stock market performance.
With an ROE of 12.5%, Azure Healthcare Limited (ASX:AZV) outpaced its own industry which delivered a less exciting 9.1% over the past year. Superficially, this looks great since we know that AZV has generated big profits with little equity capital; however, ROE doesn’t tell us how much AZV has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether AZV’s ROE is actually sustainable.
View our latest analysis for Azure Healthcare
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Azure Healthcare’s profit relative to its shareholders’ equity. An ROE of 12.5% implies A$0.12 returned on every A$1 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
Returns are usually compared to costs to measure the efficiency of capital. Azure Healthcare’s cost of equity is 8.6%. This means Azure Healthcare returns enough to cover its own cost of equity, with a buffer of 3.9%. 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
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 reveals how much revenue can be generated from Azure Healthcare’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 Azure Healthcare’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 6.8%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Azure Healthcare’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.