RXP Services Limited’s (ASX:RXP) most recent return on equity was a substandard 8.40% relative to its industry performance of 15.29% 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 RXP’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of RXP’s returns. View our latest analysis for RXP Services
What you must know about ROE
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. 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 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 RXP Services, which is 8.55%. Since RXP Services’s return does not cover its cost, with a difference of -0.15%, this means its current use of equity is not efficient and not sustainable. Very simply, RXP Services 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue RXP Services 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 the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine RXP Services’s debt-to-equity level. At 12.61%, RXP Services’s debt-to-equity ratio appears low and indicates that RXP Services still has room to increase leverage and grow its profits.