With an ROE of 9.95%, Gateway Lifestyle Group (ASX:GTY) returned in-line to its own industry which delivered 10.59% over the past year. But what is more interesting is whether GTY can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of GTY’s returns. View 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. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Diversified Real Estate Activities 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 Gateway Lifestyle Group 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 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 Gateway Lifestyle Group, which is 8.55%. Gateway Lifestyle Group’s ROE exceeds its cost by 1.40%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than Gateway Lifestyle Group’s case of positive discrepancy. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Gateway Lifestyle Group can make from its 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. We can assess whether Gateway Lifestyle Group is fuelling ROE by excessively raising debt. Ideally, Gateway Lifestyle Group 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 32.81%, meaning Gateway Lifestyle Group 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. While Gateway Lifestyle Group exhibits a weak ROE against its peers, its returns are sufficient enough to cover its 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. Although ROE can be a useful metric, it is only a small part of diligent research.
For Gateway Lifestyle Group, I’ve compiled three important 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 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.
- 3. 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!