Apollo Investment Corporation (NASDAQ:AINV) generated a below-average return on equity of 5.89% in the past 12 months, while its industry returned 11.19%. AINV’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 AINV’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of AINV’s returns. See our latest analysis for AINV
Breaking down Return on Equity
Return on Equity (ROE) is a measure of AINV’s profit relative to its shareholders’ equity. An ROE of 5.89% implies $0.06 returned on every $1 invested. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. AINV’s cost of equity is 11.51%. Since AINV’s return does not cover its cost, with a difference of -5.62%, this means its current use of equity is not efficient and not sustainable. Very simply, AINV pays more for its capital than what it generates in return. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue AINV can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable AINV’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt AINV currently has. At 62.31%, AINV’s debt-to-equity ratio appears sensible and indicates its ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? AINV exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as AINV 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 AINV 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 Apollo Investment 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.