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This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
With an ROE of 7.5%, One Liberty Properties Inc (NYSE:OLP) outpaced its own industry which delivered a less exciting 6.6% over the past year. While the impressive ratio tells us that OLP has made significant profits from little equity capital, ROE doesn’t tell us if OLP has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable OLP’s ROE is.
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs One Liberty Properties’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 One Liberty Properties, which is 8.6%. Since One Liberty Properties’s return does not cover its cost, with a difference of -1.1%, this means its current use of equity is not efficient and not sustainable. Very simply, One Liberty Properties pays more 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from One Liberty Properties’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine One Liberty Properties’s debt-to-equity level. The debt-to-equity ratio currently stands at a balanced 136%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. One Liberty Properties’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For One Liberty Properties, there are three relevant aspects you should further research:
Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
Valuation: What is One Liberty Properties worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether One Liberty Properties is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of One Liberty Properties? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past 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. For errors that warrant correction please contact the editor at firstname.lastname@example.org.