With A Recent ROE Of 4.65%, Can Alumina Limited (ASX:AWC) Catch Up To Its Industry?
Alumina Limited (ASX:AWC) generated a below-average return on equity of 4.65% in the past 12 months, while its industry returned 10.23%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into AWC's past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of AWC's returns. Let me show you what I mean by this. View our latest analysis for Alumina
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 4.65% implies $0.05 returned on every $1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. AWC’s cost of equity is 9.73%. Given a discrepancy of -5.08% between return and cost, this indicated that AWC may be paying more for its capital than what it’s generating in return. ROE can be split up into three useful 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 shows how much revenue AWC can generate with its current 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 AWC’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 5.68%, which means AWC still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? AWC’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means AWC still has room to improve shareholder returns by raising debt to fund new investments.
Are you a potential investor? If AWC 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 Alumina to help you make a more informed investment decision. If you are not interested in AWC 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.
