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Stockland (ASX:SGP) delivered a less impressive 11.38% ROE over the past year, compared to the 13.45% return generated by its industry. SGP’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on SGP’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of SGP’s returns. Check out our latest analysis for Stockland
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 11.38% implies A$0.11 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 Stockland’s equity capital deployed. Its cost of equity is 8.55%. While Stockland’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for Stockland which is encouraging. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Stockland can generate with its current 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 artificially increased through excessive borrowing, we should check Stockland’s historic debt-to-equity ratio. At 36.69%, Stockland’s debt-to-equity ratio appears low and indicates that Stockland still has room to increase leverage and grow its profits.
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. Even though Stockland returned below the industry average, its ROE comes in excess of its cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of Stockland’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.