Why Telekom Austria Aktiengesellschaft's (VIE:TKA) ROE Of 11.70% Does Not Tell The Whole Story

Telekom Austria Aktiengesellschaft (WBAG:TKA) performed in line with its integrated telecommunication services industry on the basis of its ROE – producing a return of11.70% relative to the peer average of 13.25% over the past 12 months. But what is more interesting is whether TKA can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of TKA's returns. See our latest analysis for Telekom Austria

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) is a measure of Telekom Austria’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. If investors diversify their portfolio by industry, they may want to maximise their return in the Integrated Telecommunication 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 Telekom Austria has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.

ROE is measured against cost of equity in order to determine the efficiency of Telekom Austria’s equity capital deployed. Its cost of equity is 8.18%. Telekom Austria’s ROE exceeds its cost by 3.52%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than Telekom Austria’s case of positive discrepancy. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Telekom Austria can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if Telekom Austria’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Telekom Austria’s debt-to-equity ratio. Currently the ratio stands at 123.94%, which is relatively balanced. This means Telekom Austria has not taken on excessive leverage, and its current ROE is driven by its ability to grow its profit without a significant debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Even though Telekom Austria returned below the industry average, its ROE comes in excess of its cost of equity. Also, 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 Telekom Austria, there are three pertinent aspects you should further research:

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 Telekom Austria 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 Telekom Austria is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Telekom Austria? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.