Roots Corporation’s (TSX:ROOT) most recent return on equity was a substandard 4.16% relative to its industry performance of 10.28% over the past year. ROOT’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 ROOT’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of ROOT’s returns. View our latest analysis for Roots
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of ROOT’s profit relative to its shareholders’ equity. An ROE of 4.16% implies CA$0.04 returned on every CA$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 Apparel Retail sector by investing in the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
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 ROOT, which is 8.49%. This means ROOT’s returns actually do not cover its own cost of equity, with a discrepancy of -4.33%. 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 ROOT is with its cost management. Asset turnover reveals how much revenue can be generated from ROOT’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable ROOT’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 ROOT’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 71.14%, which is sensible and indicates ROOT has not taken on too much leverage. Thus, we can conclude its current ROE is generated from its capacity to increase profit without a large debt burden.
ROE – More than just a profitability ratio
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. ROOT exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of ROOT’s return with a possible increase should the company decide to increase its debt levels. However, there are other crucial measures we need to account for before determining whether or not its returns are sustainable. I recommend you see our latest FREE analysis report to find out more about these measures!
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