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Auckland International Airport Limited (NZSE:AIA) delivered a less impressive 8.70% ROE over the past year, compared to the 11.45% return generated by its industry. Though AIA’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on AIA’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of AIA’s returns. Let me show you what I mean by this. See our latest analysis for Auckland International Airport
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Auckland International Airport’s profit relative to its shareholders’ equity. For example, if the company invests NZ$1 in the form of equity, it will generate NZ$0.09 in earnings from this. 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
Returns are usually compared to costs to measure the efficiency of capital. Auckland International Airport’s cost of equity is 8.55%. While Auckland International Airport’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for Auckland International Airport which is encouraging. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Auckland International Airport’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 Auckland International Airport currently has. The debt-to-equity ratio currently stands at a sensible 55.76%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.