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Vital Healthcare Property Trust (NZSE:VHP) outperformed the Healthcare REITs industry on the basis of its ROE – producing a higher 24.01% relative to the peer average of 8.75% over the past 12 months. On the surface, this looks fantastic since we know that VHP 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 VHP’s ROE is actually sustainable. See our latest analysis for Vital Healthcare Property Trust
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. An ROE of 24.01% implies NZ$0.24 returned on every NZ$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 Vital Healthcare Property Trust’s equity capital deployed. Its cost of equity is 8.55%. Since Vital Healthcare Property Trust’s return covers its cost in excess of 15.46%, its use of equity capital is efficient and likely to be sustainable. Simply put, Vital Healthcare Property Trust pays less for its capital than what it generates 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Vital Healthcare Property Trust can generate with its current 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 financial leverage can artificially inflate ROE, we need to look at how much debt Vital Healthcare Property Trust currently has. Currently the debt-to-equity ratio stands at a reasonable 51.83%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Vital Healthcare Property Trust 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.