America First Multifamily Investors LP. (NASDAQ:ATAX) performed in-line with its thrifts and mortgage finance industry on the basis of its ROE – producing a return of7.51% relative to the peer average of 4.99% over the past 12 months. But what is more interesting is whether ATAX can sustain this level of return. A measure of sustainable returns is ATAX’s financial leverage. If ATAX 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. Check out our latest analysis for America First Multifamily Investors
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. 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 Thrifts and Mortgage Finance 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 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 America First Multifamily Investors, which is 9.78%. This means America First Multifamily Investors’s returns actually do not cover its own cost of equity, with a discrepancy of -2.27%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from America First Multifamily Investors’s 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. 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 America First Multifamily Investors’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a high 157.95%, meaning America First Multifamily Investors may have taken on a disproportionate level of debt which is driving the high return. The company’s ability to produce profit growth may hinge on its big debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. America First Multifamily Investors exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. Its debt level is above equity which means its above-industry ROE may be driven by debt funding which raises concerns over the sustainability of America First Multifamily Investors’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For America First Multifamily Investors, I’ve compiled three relevant factors you should further research:
- 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 America First Multifamily Investors 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 America First Multifamily Investors is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of America First Multifamily Investors? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!