Dexus (ASX:DXS) generated a below-average return on equity of 15.47% in the past 12 months, while its industry returned 15.74%. DXS's results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on DXS’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of DXS's returns. Let me show you what I mean by this. View our latest analysis for Dexus

What you must know about ROE

Return on Equity (ROE) is a measure of DXS’s profit relative to its shareholders’ equity. It essentially shows how much DXS 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

ROE is measured against cost of equity in order to determine the efficiency of DXS’s equity capital deployed. Its cost of equity is 8.55%. Some of DXS’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 DXS which is reassuring. ROE can be broken down into three different 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. The other component, asset turnover, illustrates how much revenue DXS can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable DXS’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine DXS’s debt-to-equity level. At 32.91%, DXS’s debt-to-equity ratio appears low and indicates that DXS still has room to increase leverage and grow its profits.

What this means for you:

Are you a shareholder? While DXS exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity, which means its generating value for shareholders. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis.

Are you a potential investor? If you are considering investing in DXS, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Dexus to help you make a more informed investment decision. If you are not interested in DXS anymore, you can use our free platform to see our list of stocks with Return on Equity over 20%.

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.