Omega Healthcare Investors Inc (NYSE:OHI) delivered a less impressive 2.70% ROE over the past year, compared to the 7.39% return generated by its industry. OHI’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 OHI’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of OHI’s returns. Let me show you what I mean by this. View our latest analysis for Omega Healthcare Investors

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs Omega Healthcare Investors’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.03 in earnings from this. 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 measured against cost of equity in order to determine the efficiency of Omega Healthcare Investors’s equity capital deployed. Its cost of equity is 9.12%. This means Omega Healthcare Investors’s returns actually do not cover its own cost of equity, with a discrepancy of -6.42%. 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. The other component, asset turnover, illustrates how much revenue Omega Healthcare Investors can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Omega Healthcare Investors currently has. The debt-to-equity ratio currently stands at a balanced 117.59%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Omega Healthcare Investors’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Omega Healthcare Investors’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For Omega Healthcare Investors, I’ve put together three pertinent factors you should further examine:

1. 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.

2. Valuation: What is Omega Healthcare Investors worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Omega Healthcare Investors is currently mispriced by the market.

3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Omega Healthcare Investors? 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 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.