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With an ROE of 14.29%, Cedar Woods Properties Limited (ASX:CWP) outpaced its own industry which delivered a less exciting 11.66% over the past year. Superficially, this looks great since we know that CWP has generated big profits with little equity capital; however, ROE doesn’t tell us how much CWP has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether CWP’s ROE is actually sustainable. Check out our latest analysis for Cedar Woods Properties
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
Returns are usually compared to costs to measure the efficiency of capital. Cedar Woods Properties’s cost of equity is 8.55%. This means Cedar Woods Properties returns enough to cover its own cost of equity, with a buffer of 5.74%. This sustainable practice implies that the company pays less for its capital than what it generates 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
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 Cedar Woods Properties 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 inflated by excessive debt, we need to examine Cedar Woods Properties’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 53.42%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Cedar Woods Properties’s ROE is impressive relative to the industry average and also covers 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.