REA Group Limited (ASX:REA) delivered a less impressive 6.30% ROE over the past year, compared to the 9.62% return generated by its industry. Though REA'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 REA's below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of REA's returns. See our latest analysis for REA
What you must know about ROE
Return on Equity (ROE) weighs REA’s profit against the level of its shareholders’ equity. For example, if REA invests $1 in the form of equity, it will generate $0.06 in earnings from this. 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
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for REA, which is 12.55%. Since REA’s return does not cover its cost, with a difference of -6.25%, this means its current use of equity is not efficient and not sustainable. Very simply, REA pays more for its capital than what it generates in return. ROE can be split up into three useful 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue REA can make from its 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 REA’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine REA’s debt-to-equity level. Currently the debt-to-equity ratio stands at a reasonable 61.26%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? REA’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means REA still has room to improve shareholder returns by raising debt to fund new investments. 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%.