Australian Finance Group Limited (ASX:AFG) delivered an ROE of 39.94% over the past 12 months, which is an impressive feat relative to its industry average of 7.45% during the same period. Superficially, this looks great since we know that AFG has generated big profits with little equity capital; however, ROE doesn’t tell us how much AFG has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether AFG’s ROE is actually sustainable. View our latest analysis for Australian Finance Group
Breaking down Return on Equity
Return on Equity (ROE) is a measure of AFG’s profit relative to its shareholders’ equity. For example, if AFG invests $1 in the form of equity, it will generate $0.4 in earnings from this. 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 AFG’s equity capital deployed. Its cost of equity is 9.44%. Since AFG’s return covers its cost in excess of 30.49%, its use of equity capital is efficient and likely to be sustainable. Simply put, AFG pays less for its capital than what it generates in return. 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
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 AFG 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 AFG’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check AFG’s historic debt-to-equity ratio. At over 2.5 times, AFG’s debt-to-equity ratio is very high and indicates the above-average ROE is generated by significant leverage levels.
What this means for you:
Are you a shareholder? AFG’s ROE is impressive relative to the industry average and also covers its cost of equity. However, its high debt level appears to be the driver of a strong ROE and is something you should be mindful of before adding more of AFG to your portfolio. 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%.