Ingenia Communities Group (ASX:INA) generated a below-average return on equity of 5.63% in the past 12 months, while its industry returned 15.57%. 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 INA’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of INA’s returns. Let me show you what I mean by this. See our latest analysis for Ingenia Communities Group
Breaking down ROE — the mother of all ratios
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. 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 Ingenia Communities Group, which is 8.55%. Given a discrepancy of -2.92% between return and cost, this indicated that Ingenia Communities Group may be paying more for its capital than what it’s generating 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 Ingenia Communities Group can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Ingenia Communities Group’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 33.18%, which means Ingenia Communities Group still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? INA’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as INA 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%.