Argosy Property Limited (NZSE:ARG) delivered a less impressive 8.17% ROE over the past year, compared to the 8.75% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into ARG’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of ARG’s returns. See our latest analysis for Argosy Property

What you must know about ROE

Return on Equity (ROE) is a measure of Argosy Property’s profit relative to its shareholders’ equity. For example, if the company invests NZ$1 in the form of equity, it will generate NZ$0.08 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Argosy Property, which is 8.55%. Given a discrepancy of -0.38% between return and cost, this indicated that Argosy Property may be paying more for its capital than what it’s generating in return. 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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Argosy Property’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Argosy Property currently has. The debt-to-equity ratio currently stands at a sensible 65.13%, meaning the ROE is a result of its capacity to produce profit growth without a huge 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. Argosy Property’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.

For Argosy Property, I’ve put together three fundamental factors you should further research:

1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

2. Valuation: What is Argosy Property worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Argosy Property is currently mispriced by the market.

3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Argosy Property? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.