Publication: Simply Wall St
Author: Ashwin Virk
Date: 19 April 2017
Over the past 12 months, Centuria Urban REIT (ASX:CUA) generated an ROE of 14.9%, implying the company created 14.9 cents on every dollar of shareholders’ invested capital. While Centuria Urban REIT turned out to be more efficient than its industry, which delivered a Return on Equity of 13.67%, there are other factors to consider before we call it superior.
Breaking down Return on Equity
ROE ratio basically calculates the net income as a percentage of total capital committed by shareholders, namely shareholders’ equity.While an ROE ratio of more than 15% would draw any investor’s attention, historically, established companies in the developed countries have delivered an ROE between 10% and 12%.
Return on Equity = Net Profit ÷ Shareholders Equity
No matter how high or low return a company generates on equity, it should be more than the cost of equity for value creation. For CUA, the cost of equity estimate comes at 8.55% based on the Capital Asset Pricing Model using the current risk free rate and a levered beta to account for financial leverage. That compares to Centuria Urban REIT’s 14.9% ROE.
Centuria Urban REIT (ASX: CUA) Last Perf Apr 19th 2017
When we break down ROE using a very popular method called Dupont Formula, it unfolds into three key ratios which are responsible for a company’s profitability: net profit margin, asset turnover, and financial leverage. While higher margin and asset turnover indicate improved efficiency, investors should be cautious about the impact of increased leverage.
A reflection of how net profit margin has affected ROE in the past can be seen in the trend of income and revenue. An investor can gauge a fair estimate of how it’s going to play out in the future by looking at the analysts’ forecasts in the years ahead.While the change in a company’s asset turnover ratio is important in assessing the quality of ROE, an equally important aspect is its comparison to the industry average. Centuria Urban REIT generated an ROA of 4.4% versus the industry’s 3.49%. For an industry, ROA, which is earnings as a percentage of assets, is a sound representation of asset turnover.
Centuria Urban REIT (ASX: CUA) Historical Debt Apr 19th 2017
The last but not the least is the financial leverage. It’s an important ratio as a company can hide its poor operating and asset-use efficiency by increasing leverage. Thus, along with ROE, we should look at the Return on capital, which reflects earnings as a percentage of overall capital employed, including debt. For CUA, ROC stood at 6% versus the industry’s 6.18%.
Why is ROE called the mother of all ratios
ROE is called the mother of all ratios for a reason. It helps gauge a company’s efficiency both through the income statement and the balance sheet, along with telling you how just changing the capital structure of the company can impact perceived return. What are the analysts thinking about Centuria Urban REIT’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
If you are not interested in CUA anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.
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