British & American Investment Trust plc (LSE:BAF) outperformed the Asset Management and Custody Banks industry on the basis of its ROE – producing a higher 13.58% relative to the peer average of 12.90% over the past 12 months. Superficially, this looks great since we know that BAF has generated big profits with little equity capital; however, ROE doesn’t tell us how much BAF has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable BAF’s ROE is. Check out our latest analysis for British & American Investment Trust
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of BAF’s profit relative to its shareholders’ equity. An ROE of 13.58% implies £0.14 returned on every £1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. BAF’s cost of equity is 10.73%. Since BAF’s return covers its cost in excess of 2.85%, its use of equity capital is efficient and likely to be sustainable. Simply put, BAF 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue BAF can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check BAF’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 19.96%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? BAF’s ROE is impressive relative to the industry average and also covers its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If you are considering investing in BAF, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on British & American Investment Trust to help you make a more informed investment decision.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.