Fletcher King Plc (AIM:FLK) performed in-line with its real estate services industry on the basis of its ROE – producing a return of14.09% relative to the peer average of 12.49% over the past 12 months. But what is more interesting is whether FLK can sustain this level of return. A measure of sustainable returns is FLK’s financial leverage. If FLK borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface. See our latest analysis for Fletcher King
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Fletcher King’s profit against the level of its shareholders’ equity. An ROE of 14.09% implies £0.14 returned on every £1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Real Estate Services industry may want to choose 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 Fletcher King 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 Fletcher King, which is 8.30%. Since Fletcher King’s return covers its cost in excess of 5.79%, its use of equity capital is efficient and likely to be sustainable. Simply put, Fletcher King pays less 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
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 Fletcher King can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if Fletcher King’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Fletcher King’s debt-to-equity ratio. Currently, Fletcher King has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
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. Fletcher King’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Fletcher King, 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 Fletcher King 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 Fletcher King is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Fletcher King? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!