I am writing today to help inform people who are new to the stock market and looking to gauge the potential return on investment in Gateway Lifestyle Group (ASX:GTY).
With an ROE of 9.95%, Gateway Lifestyle Group (ASX:GTY) returned in-line to its own industry which delivered 11.22% over the past year. But what is more interesting is whether GTY 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 GTY’s returns. Check out our latest analysis for Gateway Lifestyle Group
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Gateway Lifestyle Group’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. If investors diversify their portfolio by industry, they may want to maximise their return in the Diversified Real Estate Activities 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 measured against cost of equity in order to determine the efficiency of Gateway Lifestyle Group’s equity capital deployed. Its cost of equity is 8.55%. Some of Gateway Lifestyle Group’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for Gateway Lifestyle Group which is reassuring. ROE can be broken down into three different 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 Gateway Lifestyle Group’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits 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 Gateway Lifestyle Group’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 32.81%, which is sensible and indicates Gateway Lifestyle Group has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and Gateway Lifestyle Group still has room to increase leverage and grow future returns.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Although Gateway Lifestyle Group’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of Gateway Lifestyle Group’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Gateway Lifestyle Group, I’ve compiled three important factors you should look at:
- 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.
- Valuation: What is Gateway Lifestyle Group 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 Gateway Lifestyle Group is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Gateway Lifestyle Group? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!