UDR Inc (NYSE:UDR) performed in line with its residential reits industry on the basis of its ROE – producing a return of5.14% relative to the peer average of 7.65% over the past 12 months. But what is more interesting is whether UDR 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 UDR’s returns. See our latest analysis for UDR
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. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 measured against cost of equity in order to determine the efficiency of UDR’s equity capital deployed. Its cost of equity is 8.59%. Since UDR’s return does not cover its cost, with a difference of -3.45%, this means its current use of equity is not efficient and not sustainable. Very simply, UDR pays more for its capital than what it generates 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue UDR 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 UDR’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 97.84%, which is relatively proportionate and indicates UDR has not taken on extreme leverage. Thus, we can conclude its current ROE is generated from its capacity to increase profit without a massive debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. UDR exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. 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 UDR, there are three important factors you should further research:
- 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 UDR 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 UDR is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of UDR? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!