United Overseas Australia Limited (ASX:UOS) delivered an ROE of 9.13% over the past 12 months, which is relatively in-line with its industry average of 11.66% during the same period. But what is more interesting is whether UOS 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 UOS’s returns. Check out our latest analysis for United Overseas Australia
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 9.13% implies A$0.09 returned on every A$1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Diversified Real Estate Activities 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
Returns are usually compared to costs to measure the efficiency of capital. United Overseas Australia’s cost of equity is 8.55%. While United Overseas Australia’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for United Overseas Australia which is encouraging. 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 United Overseas Australia’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 United Overseas Australia’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a sensible 9.08%, meaning United Overseas Australia 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.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Although United Overseas Australia’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 United Overseas Australia’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 United Overseas Australia, there are 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. Future Earnings: How does United Overseas Australia’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of United Overseas Australia? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!