Centuria Metropolitan REIT (ASX:CMA) delivered a less impressive 11.07% ROE over the past year, compared to the 15.57% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into CMA’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of CMA’s returns. See our latest analysis for Centuria Metropolitan 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. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 Centuria Metropolitan REIT’s equity capital deployed. Its cost of equity is 8.55%. Some of Centuria Metropolitan REIT’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for Centuria Metropolitan REIT which is reassuring. 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. The other component, asset turnover, illustrates how much revenue Centuria Metropolitan REIT can make from its 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 Centuria Metropolitan REIT’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 45.12%, which means Centuria Metropolitan REIT still has headroom to take on more leverage in order to increase profits.