Regional Express Holdings Limited’s (ASX:REX) most recent return on equity was a substandard 6.60% relative to its industry performance of 18.66% over the past year. 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 REX’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of REX’s returns. Let me show you what I mean by this. Check out our latest analysis for Regional Express Holdings

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs Regional Express Holdings’s profit against the level of its shareholders’ equity. An ROE of 6.60% implies A$0.07 returned on every A$1 invested. 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 Regional Express Holdings’s equity capital deployed. Its cost of equity is 8.55%. Since Regional Express Holdings’s return does not cover its cost, with a difference of -1.95%, this means its current use of equity is not efficient and not sustainable. Very simply, Regional Express Holdings pays more for its capital than what it generates in return. 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

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 shows how much revenue Regional Express Holdings can generate with its current 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 Regional Express Holdings currently has. The debt-to-equity ratio currently stands at a low 12.03%, meaning Regional Express Holdings still has headroom to borrow debt to increase profits.

What this means for you:

Are you a shareholder? REX exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as REX 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%.