With an ROE of 14.37%, Blackwall Property Trust (ASX:BWR) outpaced its own industry which delivered a less exciting 13.45% over the past year. While the impressive ratio tells us that BWR has made significant profits from little equity capital, ROE doesn’t tell us if BWR has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether BWR’s ROE is actually sustainable. View our latest analysis for Blackwall Property Trust

What you must know about ROE

Return on Equity (ROE) is a measure of Blackwall Property Trust’s profit relative to its 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. Blackwall Property Trust’s cost of equity is 8.55%. Given a positive discrepancy of 5.82% between return and cost, this indicates that Blackwall Property Trust pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 Blackwall Property Trust 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 financial leverage can artificially inflate ROE, we need to look at how much debt Blackwall Property Trust currently has. Currently the debt-to-equity ratio stands at a reasonable 86.96%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

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. Blackwall Property Trust’s above-industry ROE is encouraging, and is also in excess of 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. Although ROE can be a useful metric, it is only a small part of diligent research.