Almost Family Inc (NASDAQ:AFAM), with a ROE of 6.2% over the past twelve months, appeared relatively inefficient compared to the broader industry, which averaged 15.61% ROE. But to make an opinion on the quality of the returns, an investor must look at the factors behind such performance. View our latest analysis for Almost Family
Breaking down Return on Equity
ROE ratio basically calculates the net income as a percentage of total capital committed by shareholders, namely shareholders’ equity. Any ROE north of 20%, implying 20 cents return on every dollar invested, is favourable for any investor. But investors seek multiple assets to diversify risk and an industry-specific comparison makes more sense to achieve the goal of choosing the best among a given lot.
Return on Equity = Net Profit ÷ Shareholders Equity
No matter how high or low return a company generates on equity, it should be more than the cost of equity for value creation. For AFAM, the cost of equity estimate comes at 8.35% based on the Capital Asset Pricing Model using the current risk free rate and a levered beta to account for financial leverage. That compares to Almost Family’s 6.2% ROE.
ROE can be broken down into three ratios using the Dupont formula. The profit margin is the income as a percentage of sales, while asset turnover highlights how efficiently a company is using the resources at its disposal. Increased leverage, primarily through raising debt, is good for a profitable company, but only to the extent it doesn’t make the firm insolvent in a time of crisis.
ROE = annual net profit ÷ shareholders’ equity
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = profit margin × asset turnover × financial leverage
A trend of profit growing faster than revenue is indicative of improvement in ROE. While investors should assess the past correlation between them, an assessment of the analysts’ profit and revenue forecast points to the most likely scenario going forward. Almost Family’s ROA over the past 12 months stood at 5.5% versus the industry’s 6.31%. Although an investor should look at multi-year asset turnover to assess its effect on the latest ROE, a quick comparison with the industry tells him whether it’s acceptable. We use ROA for the comparison as along with sales, used in asset turnover, earnings, used in ROA, are also comparable within the industry.
We can assess whether AFAM is fuelling ROE by excessively raising debt or it has a balanced capital structure by looking at the historic debt-equity trend of the company. While Almost Family’s debt to equity ratio currently stands at 0.49, investors should assess how it has changed over the past few years. To account for leverage, we should look at AFAM’s Return on capital, which stood at 8% in the past year versus industry’s 2.37%. ROC is earnings as a percentage of overall employed capital compared to just equity as in the case of ROE.
ROE – More than just a profitability ratio
While ROE can be calculated through a very simple calculation, investors should look at various ratios by breaking it down and how each of them affects the return to understand the strengths and weakness of a company. It’s one of the few ratios which stitches together performance metrics from the income statement and the balance sheet. What are the analysts’ projection of Almost Family’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
If you are not interested in AFAM anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.