This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Augusta Capital Limited (NZSE:AUG) delivered a less impressive 1.2% ROE over the past year, compared to the 10.4% return generated by its industry. 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 AUG’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of AUG’s returns. Let me show you what I mean by this.
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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. An ROE of 1.2% implies NZ$0.012 returned on every NZ$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
ROE is measured against cost of equity in order to determine the efficiency of Augusta Capital’s equity capital deployed. Its cost of equity is 9.0%. This means Augusta Capital’s returns actually do not cover its own cost of equity, with a discrepancy of -7.8%. This isn’t sustainable as it implies, very simply, that the company 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Augusta Capital can make from its 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 Augusta Capital’s debt-to-equity level. Currently the debt-to-equity ratio stands at a reasonable 52.2%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.