Apartment Investment and Management Company (NYSE:AIV) delivered an ROE of 13.74% over the past 12 months, which is an impressive feat relative to its industry average of 7.56% during the same period. But what is more interesting is whether AIV can sustain this above-average ratio. This can be measured by looking at the company’s financial leverage. With more debt, AIV 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. Check out our latest analysis for Apartment Investment and Management
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Apartment Investment and Management’s profit against the level of its shareholders’ equity. An ROE of 13.74% implies $0.14 returned on every $1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Residential REITs 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
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 Apartment Investment and Management, which is 8.49%. Since Apartment Investment and Management’s return covers its cost in excess of 5.25%, its use of equity capital is efficient and likely to be sustainable. Simply put, Apartment Investment and Management pays less 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Apartment Investment and Management can make from its 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 Apartment Investment and Management’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands is significantly high, above 2.5 times, meaning Apartment Investment and Management has taken on a disproportionately large level of debt which is driving the high return. The company’s ability to produce profit growth hinges on its large 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. Apartment Investment and Management exhibits a strong ROE against its peers, as well as sufficient returns to cover its 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Apartment Investment and Management, I’ve compiled three important aspects you should further examine:
- 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 Apartment Investment and Management 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 Apartment Investment and Management is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Apartment Investment and Management? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!