TT Electronics plc’s (LSE:TTG) ROE of 7.9% over the past year, compared to its industry’s 15.38%, indicates that investors would have been better off choosing the broader industry in terms of returns generated on their committed capital. However, there is more to a company’s ROE than just the blunt-final-figure. That’s why I always advise investors to analyze the ROE at a much lower level and consider the numerous factors that affect a company’s past performance. Check out our latest analysis for TT Electronics
Peeling the layers of ROE – trisecting a company’s profitability
ROE is one of the most popular ratios to calculate the profitability of a company. The ratio is arrived by putting net earnings in the numerator and shareholders’ equity in the denominator.While an ROE ratio of more than 15% would draw any investor’s attention, historically, established companies in the developed countries have delivered an ROE between 10% and 12%.
Return on Equity = Net Profit ÷ Shareholders Equity
No matter how high or low return a company generates on equity, it should be more than the cost of equity for value creation. For TTG, the cost of equity estimate comes at 11.01% based on the Capital Asset Pricing Model using the current risk free rate and a levered beta to account for financial leverage. That compares to TT Electronics’s 7.9% ROE.
When we break down ROE using a very popular method called Dupont Formula, it unfolds into three key ratios which are responsible for a company’s profitability: net profit margin, asset turnover, and financial leverage. While higher margin and asset turnover indicate improved efficiency, investors should be cautious about the impact of increased leverage.
ROE = annual net profit ÷ shareholders’ equity
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = profit margin × asset turnover × financial leverage
Among the ratios affecting ROE, the profit margin is the most important as it highlights the operational efficiency of a company. To a potential investor, the ideal scenario would be profit increasing at a higher rate than the revenue.While the change in a company’s asset turnover ratio is important in assessing the quality of ROE, an equally important aspect is its comparison to the industry average. TT Electronics generated an ROA of 3.8% versus the industry’s 7.33%. For an industry, ROA, which is earnings as a percentage of assets, is a sound representation of asset turnover.
The last but not the least is the financial leverage. It’s an important ratio as a company can hide its poor operating and asset-use efficiency by increasing leverage. Thus, along with ROE, we should look at the Return on capital, which reflects earnings as a percentage of overall capital employed, including debt. For TTG, ROC stood at 7% versus the industry’s 11.5%.
ROE – It’s not just another ratio
ROE is called the mother of all ratios for a reason. It helps gauge a company’s efficiency both through the income statement and the balance sheet, along with telling you how just changing the capital structure of the company can impact perceived return. What are the analysts thinking about TT Electronics’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
If you are not interested in TTG anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.