Ambition Group Limited’s (ASX:AMB) most recent return on equity was a substandard 7.03% relative to its industry performance of 16.08% over the past year. AMB’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 AMB’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of AMB’s returns. Let me show you what I mean by this. See our latest analysis for AMB
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if AMB invests A$1 in the form of equity, it will generate A$0.07 in earnings from this. Investors seeking to maximise their return in the Human Resource and Employment Services industry may want to choose the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as 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 AMB, which is 10.36%. Since AMB’s return does not cover its cost, with a difference of -3.33%, this means its current use of equity is not efficient and not sustainable. Very simply, AMB 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:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from AMB’s 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 AMB’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 AMB’s debt-to-equity ratio to examine sustainability of its returns. Currently, AMB has no debt which means its returns are driven purely by equity capital. This could explain why AMB’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE – More than just a profitability ratio
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. AMB’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of AMB’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For Ambition Group, I’ve put together three pertinent factors you should further research:
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 AMB 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 AMB is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of AMB? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!