Plaza Retail REIT (TSX:PLZ.UN) delivered an unimpressive 6.37% ROE over the past year, compared to the 12.32% return generated by its industry. Though PLZ.UN’s recent performance is underwhelming, it is insightful to understand the components of ROE and how it should be interpreted. Knowing these components may alter your views on PLZ.UN’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of PLZ.UN’s returns. View our latest analysis for Plaza Retail REIT
Breaking down Return on Equity
Return on Equity (ROE) weighs PLZ.UN’s profit against the level of its shareholders’ equity.It essentially shows how much PLZ.UN can generate in earnings given the amount of equity it has raised.Investors that are diversifying their portfolio based on industry may want to maximise their return in the Retail REITs sector by choosing 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. PLZ.UN’s cost of equity is 8.49%. This means PLZ.UN’s returns actually do not cover its own cost of equity, with a discrepancy of -2.13%. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient PLZ.UN is with its cost management.Asset turnover reveals how much revenue can be generated from PLZ.UN’s asset base.The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage.We can determine if PLZ.UN’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 PLZ.UN’s debt-to-equity ratio. Currently the ratio stands at 118.91%, which is relatively balanced. This means PLZ.UN has not taken on excessive leverage, and its current ROE is driven by its ability to grow its profit without a significant debt burden.
ROE – More than just a profitability ratio
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. PLZ.UN 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. Though there are other vital factors we need to consider before we conclude whether or not PLZ.UN’s returns are sustainable. I recommend you see our latest FREE analysis report to find out more about these measures!
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