The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
Equity Residential (NYSE:EQR) performed in line with its residential reits industry on the basis of its ROE – producing a return of 6.43% relative to the peer average of 7.38% over the past 12 months. But what is more interesting is whether EQR can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of EQR’s returns.
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 6.43% implies $0.064 returned on every $1 invested, so the higher the return, the better. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Residential 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 Equity Residential 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 Equity Residential’s equity capital deployed. Its cost of equity is 8.59%. This means Equity Residential’s returns actually do not cover its own cost of equity, with a discrepancy of -2.17%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be dissected into three distinct 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 Equity Residential can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. 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 Equity Residential’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a sensible 79.66%, meaning Equity Residential has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge 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. Equity Residential’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Equity Residential, I’ve compiled three relevant factors 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 Equity Residential 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 Equity Residential is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Equity Residential? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!