Why AFH Financial Group Plc’s (LON:AFHP) ROE Of 7.74% Does Not Tell The Whole Story
AFH Financial Group Plc (AIM:AFHP) generated a below-average return on equity of 7.74% in the past 12 months, while its industry returned 13.55%. AFHP’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 AFHP’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of AFHP’s returns. Let me show you what I mean by this. Check out our latest analysis for AFH Financial Group
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company 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 AFH Financial Group, which is 9.61%. This means AFH Financial Group’s returns actually do not cover its own cost of equity, with a discrepancy of -1.87%. This isn’t sustainable as it implies, very simply, that the company 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:
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 the business is with its cost management. Asset turnover reveals how much revenue can be generated from AFH Financial Group’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt AFH Financial Group currently has. Currently the debt-to-equity ratio stands at a low 10.93%, which means AFH Financial Group still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? AFHP exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means AFHP 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 AFHP, 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 AFH Financial Group 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.
