Tahoe Resources Inc’s (TSX:THO) most recent return on equity was a substandard 0.009% relative to its industry performance of 12.60% over the past year. THO’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 THO’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of THO’s returns. See our latest analysis for Tahoe Resources
Breaking down Return on Equity
Return on Equity (ROE) weighs Tahoe Resources’s profit against the level of its shareholders’ equity. For example, if the company invests CA$1 in the form of equity, it will generate CA$0 in earnings from this. Investors seeking to maximise their return in the Gold industry may want to choose 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 Tahoe Resources, which is 17.56%. This means Tahoe Resources’s returns actually do not cover its own cost of equity, with a discrepancy of -17.55%. 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 split up into three useful 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 shows how much revenue Tahoe Resources can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. We can assess whether Tahoe Resources is fuelling ROE by excessively raising debt. Ideally, Tahoe Resources should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently Tahoe Resources has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why Tahoe Resources’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
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. Tahoe Resources’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, 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 Tahoe Resources, there are three relevant aspects you should further examine:
- 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.
- Future Earnings: How does Tahoe Resources’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Tahoe Resources? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!