Almost Family Inc (NASDAQ:AFAM) generated a below-average return on equity of 5.02% in the past 12 months, while its industry returned 14.78%. AFAM’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 AFAM’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of AFAM’s returns. Let me show you what I mean by this. See our latest analysis for AFAM
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of AFAM’s profit relative to its shareholders’ equity. It essentially shows how much AFAM 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 AFAM, which is 8.49%. Since AFAM’s return does not cover its cost, with a difference of -3.47%, this means its current use of equity is not efficient and not sustainable. Very simply, AFAM pays more for its capital than what it generates in return. ROE can be broken down into three different 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 AFAM is with its cost management. Asset turnover reveals how much revenue can be generated from AFAM’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable AFAM’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine AFAM’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 27.56%, which means AFAM still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? AFAM’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as AFAM 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 you are considering investing in AFAM, 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 Almost Family 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.