Atlas Financial Holdings Inc’s (NASDAQ:AFH) most recent return on equity was a substandard 1.33% relative to its industry performance of 9.43% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into AFH’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of AFH’s returns. Let me show you what I mean by this. Check out our latest analysis for Atlas Financial Holdings
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Atlas Financial Holdings’s profit against the level of 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 Property and Casualty Insurance sector by choosing 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
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 Atlas Financial Holdings, which is 8.49%. Given a discrepancy of -7.16% between return and cost, this indicated that Atlas Financial Holdings may be paying more for its capital than what it’s generating in return. ROE can be dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
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. Asset turnover reveals how much revenue can be generated from Atlas Financial Holdings’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 Atlas Financial Holdings’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a sensible 16.60%, meaning Atlas Financial Holdings 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.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Atlas Financial Holdings’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Atlas Financial Holdings’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 Atlas Financial Holdings, there are three essential factors you should look at:
- 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. Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for Atlas Financial Holdings’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Atlas Financial 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!