Terreno Realty Corporation (NYSE:TRNO) delivered a less impressive 5.17% ROE over the past year, compared to the 7.33% return generated by its industry. TRNO’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 TRNO’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of TRNO’s returns. Check out our latest analysis for Terreno Realty

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) is a measure of Terreno Realty’s profit relative to its shareholders’ equity. For example, if the company 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

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 Terreno Realty, which is 8.49%. This means Terreno Realty’s returns actually do not cover its own cost of equity, with a discrepancy of -3.33%. 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

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 Terreno Realty can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Terreno Realty’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 44.93%, meaning Terreno Realty still has headroom to borrow debt to increase profits.

Next Steps:

While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Terreno Realty 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 Terreno Realty’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.