This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between company’s fundamentals and stock market performance.
GDI Property Group’s (ASX:GDI) most recent return on equity was a substandard 11.0% relative to its industry performance of 12.0% over the past year. 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 GDI’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of GDI’s returns.
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Breaking down Return on Equity
Return on Equity (ROE) weighs GDI Property Group’s profit against the level of its shareholders’ equity. An ROE of 11.0% implies A$0.11 returned on every A$1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. GDI Property Group’s cost of equity is 8.6%. GDI Property Group’s ROE exceeds its cost by 2.4%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than GDI Property Group’s case of positive discrepancy. 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 shows how much revenue GDI Property Group 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 GDI Property Group currently has. Currently the debt-to-equity ratio stands at a low 13.2%, which means GDI Property Group still has headroom to take on more leverage in order to increase profits.