This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Kinder Morgan Canada Limited (TSE:KML) performed in line with its oil and gas storage and transportation industry on the basis of its ROE – producing a return of 4.35% relative to the peer average of 5.90% over the past 12 months. But what is more interesting is whether KML 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 KML’s returns. Let me show you what I mean by this. View out our latest analysis for Kinder Morgan Canada
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Oil and Gas Storage and Transportation sector by choosing 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 Kinder Morgan Canada, which is 11.27%. Given a discrepancy of -6.92% between return and cost, this indicated that Kinder Morgan Canada may be paying more for its capital than what it’s generating in return. ROE can be dissected into three distinct 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 the business is with its cost management. Asset turnover reveals how much revenue can be generated from Kinder Morgan Canada’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 determine if Kinder Morgan Canada’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 Kinder Morgan Canada’s debt-to-equity ratio. Currently the ratio stands at 2.75%, which is very low. This means Kinder Morgan Canada has not taken on leverage, which could explain its below-average ROE. Kinder Morgan Canada still has headroom to take on more leverage in order to grow its returns.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Kinder Morgan Canada’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Kinder Morgan Canada’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For Kinder Morgan Canada, there are three important factors you should look at:
- 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 Kinder Morgan Canada 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 Kinder Morgan Canada is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Kinder Morgan Canada? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!