What You Must Know About Alleghany Corporation’s (NYSE:Y) Return on Equity
Alleghany Corporation’s (NYSE:Y) most recent return on equity was a substandard 0.15% relative to its industry performance of 9.11% over the past year. Y’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on Y’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of Y’s returns. View our latest analysis for Alleghany
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Alleghany’s profit against the level of its shareholders’ equity. An ROE of 0.15% implies $0 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. Alleghany’s cost of equity is 8.62%. Given a discrepancy of -8.47% between return and cost, this indicated that Alleghany may be paying more for its capital than what it’s generating in return. ROE can be dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
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 Alleghany’s 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 Alleghany’s historic debt-to-equity ratio. At 17.90%, Alleghany’s debt-to-equity ratio appears low and indicates that Alleghany still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? Y’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as Y still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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 Y has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Alleghany 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.
