I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
With an ROE of 22.66%, FRP Holdings Inc (NASDAQ:FRPH) outpaced its own industry which delivered a less exciting 10.62% over the past year. Though, the impressiveness of FRPH’s ROE is contingent on whether this industry-beating level can be sustained. This can be measured by looking at the company’s financial leverage. With more debt, FRPH can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further. View out our latest analysis for FRP Holdings
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 22.66% implies $0.23 returned on every $1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Real Estate Operating Companies industry may want to choose 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
Returns are usually compared to costs to measure the efficiency of capital. FRP Holdings’s cost of equity is 8.59%. Given a positive discrepancy of 14.07% between return and cost, this indicates that FRP Holdings pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 FRP Holdings’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if FRP Holdings’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 FRP Holdings’s debt-to-equity ratio. The ratio currently stands at a sensible 44.17%, meaning FRP Holdings has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. FRP Holdings’s above-industry ROE is encouraging, and is also in excess of its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For FRP Holdings, there are three pertinent aspects you should further examine:
- 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 FRP Holdings 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 FRP Holdings is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of FRP 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!