Charter Hall Retail REIT (ASX:CQR) delivered an ROE of 15.67% over the past 12 months, which is an impressive feat relative to its industry average of 14.36% during the same period. However, whether this above-industry ROE is actually impressive depends on if it can be maintained. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this. See our latest analysis for CQR
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity.An ROE of 15.67% implies $0.16 returned on every $1 invested, so the higher the return, the better.If investors diversify their portfolio by industry, they may want to maximise their return in the Retail REITs sector by investing in 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 CQR’s equity capital deployed. Its cost of equity is 8.55%. This means CQR returns enough to cover its own cost of equity, with a buffer of 7.12%. This sustainable practice implies that the company 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses.Asset turnover shows how much revenue CQR can generate with its current 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 CQR’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 CQR’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at 54.40%, which is reasonable. This means CQR has not taken on too much leverage, and its above-average ROE is driven by its ability to grow its profit without a huge debt burden.
ROE – More than just a profitability ratio
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. CQR’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Though there are other vital factors we need to consider before we conclude whether or not CQR’s returns are sustainable. I recommend you see our latest FREE analysis report to find out more about other measures!
If you are not interested in CQR anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.
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