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.
Equinix Inc (REIT) (NASDAQ:EQIX) delivered an ROE of 4.0% over the past 12 months, which is relatively in-line with its industry average of 6.6% during the same period. But what is more interesting is whether EQIX can sustain or improve on this level of return. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of EQIX’s returns. Let me show you what I mean by this.
Breaking down Return on Equity
Return on Equity (ROE) weighs Equinix (REIT)’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.040 in earnings from this. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Specialized REITs sector by choosing 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 Equinix (REIT) 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 measured against cost of equity in order to determine the efficiency of Equinix (REIT)’s equity capital deployed. Its cost of equity is 8.6%. Given a discrepancy of -4.6% between return and cost, this indicated that Equinix (REIT) 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Equinix (REIT) can make from its 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. We can assess whether Equinix (REIT) is fuelling ROE by excessively raising debt. Ideally, Equinix (REIT) should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands at a high 164%, meaning Equinix (REIT) may have taken on a disproportionate level of debt which is driving its 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. Equinix (REIT) exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Also, with debt capital in excess of equity, ROE may already be inflated by the use of debt funding, raising questions over the possibility of further decline in the company’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Equinix (REIT), I’ve compiled three relevant aspects you should look at:
- 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.
- Valuation: What is Equinix (REIT) 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 Equinix (REIT) is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Equinix (REIT)? 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.