APA Group (ASX:APA) delivered a less impressive 5.92% ROE over the past year, compared to the 9.52% return generated by its industry. Though APA'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 APA's below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of APA's returns. Check out our latest analysis for APA Group

Breaking down Return on Equity

Return on Equity (ROE) is a measure of APA’s profit relative to its shareholders’ equity. It essentially shows how much APA can generate in earnings given the amount of equity it has raised. 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

ROE is measured against cost of equity in order to determine the efficiency of APA’s equity capital deployed. Its cost of equity is 8.55%. Since APA’s return does not cover its cost, with a difference of -2.64%, this means its current use of equity is not efficient and not sustainable. Very simply, APA 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 APA is with its cost management. Asset turnover shows how much revenue APA can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable APA’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine APA’s debt-to-equity level. The debt-to-equity ratio currently stands at over 2.5 times, meaning the below-average ratio is already being driven by a large amount of debt.

What this means for you:

Are you a shareholder? APA’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Additionally, its high debt level appears to be a key driver of its ROE and is something you should be mindful of before adding more of APA to your portfolio.

Are you a potential investor? If you are considering investing in APA, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on APA Group to help you make a more informed investment decision. If you are not interested in APA 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.