American Equity Investment Life Holding Company (NYSE:AEL) delivered an ROE of 9.28% over the past 12 months, which is an impressive feat relative to its industry average of 8.00% during the same period. While the impressive ratio tells us that AEL has made significant profits from little equity capital, ROE doesn’t tell us if AEL has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether AEL’s ROE is actually sustainable. View our latest analysis for American Equity Investment Life Holding
What you must know about ROE
Return on Equity (ROE) weighs AEL’s profit against the level of its shareholders’ equity. It essentially shows how much AEL can generate in earnings given the amount of equity it has raised. 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
ROE is measured against cost of equity in order to determine the efficiency of AEL’s equity capital deployed. Its cost of equity is 10.62%. This means AEL’s returns actually do not cover its own cost of equity, with a discrepancy of -1.35%. This isn’t sustainable as it implies, very simply, that the company pays more 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 AEL can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine AEL’s debt-to-equity level. At 27.56%, AEL’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? AEL’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. Since its high ROE is not fuelled by unsustainable debt, investors shouldn’t give up as AEL still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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%.