Mirrabooka Investments Limited (ASX:MIR) delivered a less impressive 2.24% ROE over the past year, compared to the 8.68% return generated by its industry. MIR’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 MIR’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of MIR’s returns. Let me show you what I mean by this. Check out our latest analysis for Mirrabooka Investments
What you must know about ROE
Return on Equity (ROE) weighs MIR’s profit against the level of its shareholders’ equity. An ROE of 2.24% implies A$0.02 returned on every A$1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. MIR’s cost of equity is 8.55%. Since MIR’s return does not cover its cost, with a difference of -6.31%, this means its current use of equity is not efficient and not sustainable. Very simply, MIR pays more 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. Asset turnover shows how much revenue MIR can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine MIR’s debt-to-equity level. Currently, MIR has no debt which means its returns are driven purely by equity capital. This could explain why MIR’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
What this means for you:
Are you a shareholder? MIR 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 MIR 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%.