This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.
AerCap Holdings NV (NYSE:AER) performed in-line with its trading companies and distributors industry on the basis of its ROE – producing a return of12.54% relative to the peer average of 12.39% over the past 12 months. However, whether this ROE is actually impressive depends on if it can be maintained. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs AerCap Holdings’s profit against the level of its shareholders’ equity. An ROE of 12.54% implies $0.13 returned on every $1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Trading Companies and Distributors 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 AerCap Holdings, which is 17.05%. Given a discrepancy of -4.51% between return and cost, this indicated that AerCap Holdings may be paying more for its capital than what it’s generating in return. 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
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 AerCap Holdings’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 AerCap Holdings’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is greater than 2.5 times which is very high, indicating AerCap Holdings’s above-average ROE is generated by its significant leverage levels and its ability to grow profit hinges on a substantial debt burden.
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. AerCap Holdings’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For AerCap Holdings, I’ve compiled three key aspects you should further research:
- 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.
- Future Earnings: How does AerCap Holdings’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.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of AerCap Holdings? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.