This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about Return on Equity using a real-life example.
Federal Agricultural Mortgage Corporation (NYSE:AGM) outperformed the Thrifts and Mortgage Finance industry on the basis of its ROE – producing a higher 12.7% relative to the peer average of 6.5% over the past 12 months. Superficially, this looks great since we know that AGM has generated big profits with little equity capital; however, ROE doesn’t tell us how much AGM has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether AGM’s ROE is actually sustainable.
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Federal Agricultural Mortgage’s profit relative to 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 measured against cost of equity in order to determine the efficiency of Federal Agricultural Mortgage’s equity capital deployed. Its cost of equity is 9.6%. Given a positive discrepancy of 3.1% between return and cost, this indicates that Federal Agricultural Mortgage pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 Federal Agricultural Mortgage can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Federal Agricultural Mortgage currently has. 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.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Federal Agricultural Mortgage’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Federal Agricultural Mortgage’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Federal Agricultural Mortgage, I’ve compiled three key aspects you should further examine:
- 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 Federal Agricultural Mortgage 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 Federal Agricultural Mortgage is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Federal Agricultural Mortgage? 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.