Yellow Brick Road Holdings Limited’s (ASX:YBR) most recent return on equity was a substandard 1.72% relative to its industry performance of 8.51% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into YBR’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of YBR’s returns. See our latest analysis for Yellow Brick Road Holdings
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 1.72% implies A$0.02 returned on every A$1 invested, so the higher the return, the better. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Other Diversified Financial Services sector by choosing the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt Yellow Brick Road Holdings has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Yellow Brick Road Holdings’s equity capital deployed. Its cost of equity is 8.55%. Since Yellow Brick Road Holdings’s return does not cover its cost, with a difference of -6.83%, this means its current use of equity is not efficient and not sustainable. Very simply, Yellow Brick Road Holdings pays more for its capital than what it generates in return. ROE can be dissected into three distinct 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 Yellow Brick Road Holdings’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Yellow Brick Road Holdings is fuelling ROE by excessively raising debt. Ideally, Yellow Brick Road Holdings should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands at a sensible 11.69%, meaning Yellow Brick Road Holdings has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden and still has headroom to grow returns to industry average.
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. Yellow Brick Road Holdings’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Yellow Brick Road Holdings’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 Yellow Brick Road Holdings, I’ve put together three pertinent aspects 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 Yellow Brick Road Holdings 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 Yellow Brick Road Holdings is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Yellow Brick Road Holdings? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!