This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Genworth Mortgage Insurance Australia Limited (ASX:GMA) performed in line with its thrifts and mortgage finance industry on the basis of its ROE – producing a return of 5.6% relative to the peer average of 7.2% over the past 12 months. But what is more interesting is whether GMA can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of GMA’s returns.
What you must know about ROE
Return on Equity (ROE) weighs Genworth Mortgage Insurance Australia’s profit against the level of its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.056 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Thrifts and Mortgage Finance sector by investing in the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Genworth Mortgage Insurance Australia’s equity capital deployed. Its cost of equity is 8.6%. Given a discrepancy of -2.9% between return and cost, this indicated that Genworth Mortgage Insurance Australia may be paying more for its capital than what it’s generating 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 the business is with its cost management. The other component, asset turnover, illustrates how much revenue Genworth Mortgage Insurance Australia can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. We can assess whether Genworth Mortgage Insurance Australia is fuelling ROE by excessively raising debt. Ideally, Genworth Mortgage Insurance Australia should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The most recent ratio is 10.8%, which is sensible and indicates Genworth Mortgage Insurance Australia has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and Genworth Mortgage Insurance Australia still has room to increase leverage and grow future returns.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Genworth Mortgage Insurance Australia’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Genworth Mortgage Insurance Australia, I’ve compiled three key factors you should further research:
- Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Valuation: What is Genworth Mortgage Insurance Australia worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? Theintrinsic value infographic in our free research report helps visualize whether Genworth Mortgage Insurance Australia is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Genworth Mortgage Insurance Australia? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past 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.