MaxFast Properties AB (publ) (OM:MAXF) generated a below-average return on equity of 8.16% in the past 12 months, while its industry returned 16.43%. 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 MAXF’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of MAXF’s returns. View our latest analysis for MaxFast Properties
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs MaxFast Properties’s profit against the level of its shareholders’ equity. For example, if the company invests SEK1 in the form of equity, it will generate SEK0.08 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of MaxFast Properties’s equity capital deployed. Its cost of equity is 9.29%. Given a discrepancy of -1.14% between return and cost, this indicated that MaxFast Properties may be paying more for its capital than what it’s generating in return. ROE can be broken down into three different 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 MaxFast Properties 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 MaxFast Properties’s debt-to-equity level. At 142.50%, MaxFast Properties’s debt-to-equity ratio appears balanced and indicates its ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. MaxFast Properties’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of MaxFast Properties’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.