The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want a simplistic look at the return on Roots Corporation (TSE:ROOT) stock.
With an ROE of 8.70%, Roots Corporation (TSE:ROOT) returned in-line to its own industry which delivered 10.50% over the past year. But what is more interesting is whether ROOT 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 ROOT’s returns. Let me show you what I mean by this. Check out our latest analysis for Roots
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Roots’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. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Apparel Retail sector by choosing 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 Roots has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Roots’s equity capital deployed. Its cost of equity is 8.49%. Roots’s ROE exceeds its cost by 0.20%, 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 Roots’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:
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 Roots’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 Roots’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 Roots’s debt-to-equity ratio. Currently the ratio stands at 50.57%, which is reasonable. This means Roots has not taken on too much leverage, and its current ROE is driven by its ability to grow its profit without a huge debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Although Roots’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of Roots’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Roots, I’ve compiled three essential 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.
- Valuation: What is Roots 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 Roots is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Roots? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!