GPT Group (ASX:GPT) delivered an ROE of 13.93% over the past 12 months, which is an impressive feat relative to its industry average of 13.45% during the same period. Superficially, this looks great since we know that GPT has generated big profits with little equity capital; however, ROE doesn’t tell us how much GPT has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable GPT’s ROE is. View our latest analysis for GPT Group

Breaking down ROE — the mother of all ratios

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.

Return on Equity = Net Profit ÷ Shareholders Equity

Returns are usually compared to costs to measure the efficiency of capital. GPT Group’s cost of equity is 8.55%. Since GPT Group’s return covers its cost in excess of 5.38%, its use of equity capital is efficient and likely to be sustainable. Simply put, GPT Group pays less for its capital than what it generates in return. ROE can be dissected into three distinct 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 GPT Group can make from its 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 GPT Group currently has. Currently the debt-to-equity ratio stands at a low 37.64%, which means its above-average ROE is driven by its ability to grow its profit without a significant 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. GPT Group’s above-industry ROE is encouraging, and is also in excess of its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.