Think Childcare Limited (ASX:TNK) delivered an ROE of 27.82% over the past 12 months, which is an impressive feat relative to its industry average of 32.28% during the same period. Though, the impressiveness of TNK’s ROE is contingent on whether this industry-beating level can be sustained. This can be measured by looking at the company’s financial leverage. With more debt, TNK can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further. See our latest analysis for TNK
What you must know about ROE
Return on Equity (ROE) is a measure of TNK’s profit relative to its shareholders’ equity.An ROE of 27.82% implies $0.28 returned on every $1 invested, so the higher the return, the better.If investors diversify their portfolio by industry, they may want to maximise their return in the Education Services 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 TNK 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 measured against cost of equity in order to determine the efficiency of TNK’s equity capital deployed. Its cost of equity is 8.55%. While TNK’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for TNK which is encouraging. ROE can be split up into three useful 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 TNK is with its cost management.Asset turnover reveals how much revenue can be generated from TNK’s asset base.And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable TNK’s capital structure is.ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at TNK’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at 48.75%, which is very low. This means TNK has not taken on leverage, which could explain its below-average ROE. TNK still has headroom to take on more leverage in order to grow its returns.
ROE – It’s not just another ratio
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. TNK’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. There are other important measures we need to consider in order to conclude on the quality of its returns. I recommend you see our latest FREE analysis report to find out more about other measures!
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