A&W Revenue Royalties Income Fund (TSX:AW.UN) delivered an ROE of 16.27% over the past 12 months, which is an impressive feat relative to its industry average of 11.15% during the same period. On the surface, this looks fantastic since we know that AW.UN has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether AW.UN’s ROE is actually sustainable. See our latest analysis for AW.UN
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of AW.UN’s profit relative to its shareholders’ equity. For example, if AW.UN invests $1 in the form of equity, it will generate $0.16 in earnings from this. 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
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for AW.UN, which is 13.09%. This means AW.UN returns enough to cover its own cost of equity, with a buffer of 3.18%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be split up into three useful 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. The other component, asset turnover, illustrates how much revenue AW.UN can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt AW.UN currently has. The debt-to-equity ratio currently stands at a low 36.98%, 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? AW.UN exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of AW.UN to your portfolio if your personal research is confirming what the ROE is telling you. 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 AW.UN, 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 A&W Revenue Royalties Income Fund 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.