Charter Hall Retail REIT (ASX:CQR) generated a below-average return on equity of 15.67% in the past 12 months, while its industry returned 15.74%. Though CQR’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 CQR’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of CQR’s returns. View our latest analysis for Charter Hall Retail REIT
Breaking down Return on Equity
Return on Equity (ROE) weighs CQR’s profit against the level of its shareholders’ equity. For example, if CQR invests $1 in the form of equity, it will generate $0.16 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
Returns are usually compared to costs to measure the efficiency of capital. CQR’s cost of equity is 8.55%. Some of CQR’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for CQR which is reassuring. 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 CQR is with its cost management. Asset turnover reveals how much revenue can be generated from CQR’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable CQR’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine CQR’s debt-to-equity level. Currently the debt-to-equity ratio stands at a reasonable 54.40%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? Even though CQR returned below the industry average, its ROE comes in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of CQR to your portfolio if your personal research is confirming what the ROE is telling you. 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%.