Aminex PLC (LSE:AEX) delivered a less impressive 0.84% ROE over the past year, compared to the 8.73% return generated by its industry. AEX’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 AEX’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of AEX’s returns. See our latest analysis for Aminex
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Aminex’s profit relative to its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.01 in earnings from this. 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 Aminex, which is 8.30%. Given a discrepancy of -7.46% between return and cost, this indicated that Aminex may be paying more for its capital than what it’s generating 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Aminex’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Aminex’s historic debt-to-equity ratio. Currently, Aminex has no debt which means its returns are driven purely by equity capital. This could explain why Aminex’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Aminex exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Aminex’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.