Oceania Capital Partners Limited’s (ASX:OCP) most recent return on equity was a substandard 8.17% relative to its industry performance of 8.68% over the past year. Though OCP’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on OCP’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of OCP’s returns. Let me show you what I mean by this. Check out our latest analysis for Oceania Capital Partners
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 Oceania Capital Partners’s equity capital deployed. Its cost of equity is 8.55%. Given a discrepancy of -0.38% between return and cost, this indicated that Oceania Capital Partners may be paying more for its capital than what it’s generating 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 Oceania Capital Partners’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 Oceania Capital Partners’s debt-to-equity level. At 11.10%, Oceania Capital Partners’s debt-to-equity ratio appears low and indicates that Oceania Capital Partners still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? OCP’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 OCP 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%.