TPG Telecom Limited (ASX:TPM) performed in line with its integrated telecommunication services industry on the basis of its ROE – producing a return of15.05% relative to the peer average of 16.50% over the past 12 months. But what is more interesting is whether TPM can sustain or improve on this level of return. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of TPM’s returns. Let me show you what I mean by this. View our latest analysis for TPG Telecom
Breaking down Return on Equity
Return on Equity (ROE) is a measure of TPG Telecom’s profit relative to its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.15 in earnings from this. Investors seeking to maximise their return in the Integrated Telecommunication Services industry may want to choose the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. TPG Telecom’s cost of equity is 8.55%. TPG Telecom’s ROE exceeds its cost by 6.50%, 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 TPG Telecom’s case of positive discrepancy. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from TPG Telecom’s asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. We can assess whether TPG Telecom is fuelling ROE by excessively raising debt. Ideally, TPG Telecom should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands at a sensible 56.13%, meaning TPG Telecom has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Although TPG Telecom’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the 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. Although ROE can be a useful metric, it is only a small part of diligent research.
For TPG Telecom, I’ve put together three fundamental factors you should further research:
- 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.
- Valuation: What is TPG Telecom 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 TPG Telecom is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of TPG Telecom? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!