Why Empire State Realty OP LP (NYSEARCA:ESBA) May Not Be As Efficient As Its Industry

This analysis is intended to introduce important early concepts to people who are starting to invest and want to better understand how you can grow your money by investing in Empire State Realty OP LP (NYSEARCA:ESBA).

Empire State Realty OP LP (NYSEARCA:ESBA) delivered an ROE of 5.94% over the past 12 months, which is relatively in-line with its industry average of 7.63% during the same period. But what is more interesting is whether ESBA can sustain or improve on this level of return. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of ESBA’s returns. View out our latest analysis for Empire State Realty OP

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

Return on Equity (ROE) weighs Empire State Realty OP’s profit against the level of its shareholders’ equity. An ROE of 5.94% implies $0.059 returned on every $1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Diversified REITs sector by investing in the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.

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 Empire State Realty OP, which is 8.59%. Given a discrepancy of -2.65% between return and cost, this indicated that Empire State Realty OP may be paying more for its capital than what it’s generating in return. ROE can be broken down into three different 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

ARCA:ESBA Last Perf June 29th 18
ARCA:ESBA Last Perf June 29th 18

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Empire State Realty OP can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at Empire State Realty OP’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at 97.21%, which is relatively balanced. This means Empire State Realty OP has not taken on excessive leverage, and its current ROE is driven by its ability to grow its profit without a significant debt burden.

ARCA:ESBA Historical Debt June 29th 18
ARCA:ESBA Historical Debt June 29th 18

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. Empire State Realty OP exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For Empire State Realty OP, I’ve compiled three pertinent factors you should further examine:

  1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
  2. Valuation: What is Empire State Realty OP worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Empire State Realty OP is currently mispriced by the market.
  3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Empire State Realty OP? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!