While Ryman Healthcare Limited’s (NZSE:RYM) 27.1% ROE was above the industry average of 14.58%, the role of leverage must also be considered. Leverage can distort an ROE to a great extent. For instance, assuming interest costs are higher than a company’s earnings. The ROE might look impressive, but in reality the shareholders will take a hit instead achieving a positive return. Check out our latest analysis for Ryman Healthcare
Peeling the layers of ROE – trisecting a company’s profitability
ROE is simply the percentage of past year earnings against the book value of shareholders’ equity, which is the sum of retained earnings and capital raised through equity offerings.Generally, an ROE of 20% or more is considered highly attractive for any investment consideration. Although, it’s more of an industry-specific ratio as the constituents share similar risk profile.
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 RYM, it stands at 8.52% versus its ROE of 27.1%. Using Dupont Analysis, we find out that ROE is composed of three ratios: profit margin, asset turnover, and financial leverage. The method reflects the impact of change in key figures in both the income statement and the balance sheet. The analysis provides a bird’s-eye view on the strengths and weaknesses of the company.
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. Ryman Healthcare generated an ROA of 0.7% versus the industry’s 6.28%. For an industry, ROA, which is earnings as a percentage of assets, is a sound representation of asset turnover.
The impact of leverage on ROE is reflected in a company’s debt-equity profile. Rapidly rising debt compared to equity, while profit margin and asset turnover underperform, raises a red flag on the ROE. It’s important as a company can inflate its ROE by consistently increasing debt despite weak operating performance. RYM’s debt to equity ratio currently stands at 0.49. Investors should be cautious about any sharp change in this ratio, more so if it’s due to increasing debt.
ROE – It’s not just another 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 Ryman Healthcare’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
If you are not interested in RYM anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.