This article is intended for those of you who are at the beginning of your investing journey
and want to begin learning the link between Ainsworth Game Technology Limited (ASX:AGI)’s return fundamentals and stock market performance.
Ainsworth Game Technology Limited’s (ASX:AGI) most recent return on equity was a substandard 7.66% relative to its industry performance of 15.20% over the past year.
Though AGI’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 AGI’s below-average returns.
I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of AGI’s returns.
Check out our latest analysis for Ainsworth Game Technology
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity.
For example, if the company invests A$1 in the form of equity, it will generate A$0.077 in earnings from this.
If investors diversify their portfolio by industry, they may want to maximise their return in the Casinos and Gaming sector by investing in the highest returning stock.
However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt Ainsworth Game Technology has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
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 Ainsworth Game Technology, which is 8.55%.
This means Ainsworth Game Technology’s returns actually do not cover its own cost of equity, with a discrepancy of -0.89%. 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:
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 Ainsworth Game Technology can make from its asset base.
The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage.
We can assess whether Ainsworth Game Technology is fuelling ROE by excessively raising debt. Ideally, Ainsworth Game Technology 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 19.44%, which is sensible and indicates Ainsworth Game Technology has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and Ainsworth Game Technology 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.
Ainsworth Game Technology’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 Ainsworth Game Technology,
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