Will Select Income REIT (SIR) Continue To Underperform Its Industry?
Select Income REIT (NASDAQ:SIR) delivered a less impressive 4.18% ROE over the past year, compared to the 8.31% return generated by its industry. Though SIR's recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on SIR's below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of SIR's returns. See our latest analysis for SIR
Breaking down Return on Equity
Return on Equity (ROE) weighs SIR’s profit against the level of its shareholders’ equity. For example, if SIR invests $1 in the form of equity, it will generate $0.04 in earnings from this. 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. SIR’s cost of equity is 9.36%. Since SIR’s return does not cover its cost, with a difference of -5.18%, this means its current use of equity is not efficient and not sustainable. Very simply, SIR pays more for its capital than what it generates 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 SIR can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable SIR’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt SIR currently has. Currently the debt-to-equity ratio stands at a balanced 123.54%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? SIR’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 SIR still has room to improve shareholder returns by raising debt to fund new investments. 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 SIR, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Select Income REIT 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.
