Centuria Metropolitan REIT (ASX:CMA), with its ROE of 20.2 over the past 12 months, performed better than the industry, which averaged 13.65% in the same period. However, investors, focused only on Return on Equity, often ignore the rising interest costs which result in actual return to be significantly lower. Thus, we must look at how a company’s debt profile changed during the same time period.
What you must know about ROE
ROE is one of the most popular ratios to calculate the profitability of a company. The ratio is arrived by putting net earnings in the numerator and shareholders’ equity in the denominator.Any ROE north of 20%, implying 20 cents return on every dollar invested, is favourable for any investor. But investors seek multiple assets to diversify risk and an industry-specific comparison makes more sense to achieve the goal of choosing the best among a given lot.
ROE above the cost of equity estimate indicates value creation, which apparently is the only reason shares rally. The cost of equity can be estimated through a popular and Nobel-prize winning method called Capital Asset Pricing Model (CAPM). With a few sets of assumptions, the CAPM pegs CMA’s cost of equity at 8.52%, compared to its ROE of 20.2%.
Centuria Metropolitan REIT (ASX:CMA) Last Perf May 15th 17
ROE can be broken down into three ratios using the Dupont formula. The profit margin is the income as a percentage of sales, while asset turnover highlights how efficiently a company is using the resources at its disposal. Increased leverage, primarily through raising debt, is good for a profitable company, but only to the extent it doesn’t make the firm insolvent in a time of crisis.
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 Metropolitan REIT generated an ROA of 4.9% versus the industry’s 3.52%. For an industry, ROA, which is earnings as a percentage of assets, is a sound representation of asset turnover.
Centuria Metropolitan REIT (ASX:CMA) Historical Debt May 15th 17
The impact of leverage on ROE is reflected in a company’s debt-equity profile. Rapidly rising debt compared to equity, while profit margin and asset turnover underperform, raises a red flag on the ROE. It’s important as a company can inflate its ROE by consistently increasing debt despite weak operating performance. CMA’s debt to equity ratio currently stands at 0.51. Investors should be cautious about any sharp change in this ratio, more so if it’s due to increasing debt.
ROE – More than just a profitability ratio
On the surface, ROE appears to be a simple profitability ratio indicating the return an investor should expect. However, for a sound investment consideration, it should still appear good when a company’s debt profile, profit-revenue trend, and leverage are considered. What do the analysts think about Centuria Metropolitan REIT’s ROE three-years ahead? I recommend you see our latest FREE analysis report to find out!
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