Altaba Inc (NASDAQ:AABA) generated a below-average return on equity of 4.73% in the past 12 months, while its industry returned 10.09%. Though AABA'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 AABA's below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of AABA's returns. View our latest analysis for Altaba

What you must know about ROE

Return on Equity (ROE) is a measure of AABA’s profit relative to its shareholders’ equity. For example, if AABA invests $1 in the form of equity, it will generate $0.05 in earnings from this. 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. AABA’s cost of equity is 11.99%. Since AABA’s return does not cover its cost, with a difference of -7.25%, this means its current use of equity is not efficient and not sustainable. Very simply, AABA 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

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 AABA 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 AABA’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check AABA’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 2.76%, which means AABA still has headroom to take on more leverage in order to increase profits.

What this means for you:

Are you a shareholder? AABA’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 AABA 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%.

Are you a potential investor? If you are considering investing in AABA, 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 Altaba to help you make a more informed investment decision.

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.