Australian Ethical Investment Ltd (ASX:AEF), with its ROE of 25.1 over the past 12 months, performed better than the industry, which averaged 18.29% in the same period. However, investors, focused only on Return on Equity, often ignore the rising interest costs which result in actual return to be significantly lower. Thus, we must look at how a company’s debt profile changed during the same time period. Check out our latest analysis for Australian Ethical Investment
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
For a company to create value for its shareholders, it must generate an ROE higher than the cost of equity. Unlike debt-holders, there is no predefined return for equity investors. However, an expected return to account for market risk can be arrived at using the Capital Asset Pricing Model. For AEF, it stands at 10.08% versus its ROE of 25.1%. 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
Among the ratios affecting ROE, the profit margin is the most important as it highlights the operational efficiency of a company. To a potential investor, the ideal scenario would be profit increasing at a higher rate than the revenue. While the change in a company’s asset turnover ratio is important in assessing the quality of ROE, an equally important aspect is its comparison to the industry average. Australian Ethical Investment generated an ROA of 19% versus the industry’s 6.91%. For an industry, ROA, which is earnings as a percentage of assets, is a sound representation of asset turnover.
We can assess whether AEF 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 Australian Ethical Investment’s debt to equity ratio currently stands at 0, investors should assess how it has changed over the past few years. To account for leverage, we should look at AEF’s Return on capital, which stood at 38% in the past year versus industry’s 9.93%. ROC is earnings as a percentage of overall employed capital compared to just equity as in the case of ROE.
Why is ROE called the mother of all ratios
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 Australian Ethical Investment’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
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