With an ROE of 14.37%, Federal Agricultural Mortgage Corporation (NYSE:AGM) outpaced its own industry which delivered a less exciting 7.15% over the past year. On the surface, this looks fantastic since we know that AGM has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of AGM’s ROE. See our latest analysis for AGM
Breaking down Return on Equity
Return on Equity (ROE) is a measure of AGM’s profit relative to its shareholders’ equity. For example, if AGM invests $1 in the form of equity, it will generate $0.14 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 measured against cost of equity in order to determine the efficiency of AGM’s equity capital deployed. Its cost of equity is 9.20%. Given a positive discrepancy of 5.17% between return and cost, this indicates that AGM pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be dissected into three distinct 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient AGM is with its cost management. Asset turnover reveals how much revenue can be generated from AGM’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable AGM’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check AGM’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its above-average ROE is driven by significant debt levels.
What this means for you:
Are you a shareholder? AGM’s above-industry ROE is encouraging, and is also in excess of its cost of equity. However, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more AGM shares.
Are you a potential investor? If you are considering investing in AGM, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Federal Agricultural Mortgage to help you make a more informed investment decision. If you are not interested in AGM anymore, you can use our free platform to see our list of stocks with Return on Equity over 20%.
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.