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Mirvac Group (ASX:MGR) outperformed the Diversified REITs industry on the basis of its ROE – producing a higher 13.59% relative to the peer average of 13.45% over the past 12 months. On the surface, this looks fantastic since we know that MGR has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether MGR’s ROE is actually sustainable. See our latest analysis for Mirvac Group
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Mirvac Group’s profit against the level of its shareholders’ equity. An ROE of 13.59% implies A$0.14 returned on every A$1 invested. 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 Mirvac Group’s equity capital deployed. Its cost of equity is 8.55%. Given a positive discrepancy of 5.04% between return and cost, this indicates that Mirvac Group pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Mirvac Group’s 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 Mirvac Group’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 39.51%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Mirvac Group exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.