I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
With an ROE of 16.50%, Cargojet Inc (TSE:CJT) outpaced its own industry which delivered a less exciting 12.47% over the past year. Though, the impressiveness of CJT’s ROE is contingent on whether this industry-beating level can be sustained. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this.
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Cargojet’s profit relative to its shareholders’ equity. An ROE of 16.50% implies CA$0.16 returned on every CA$1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Air Freight and Logistics industry may want to choose 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 Cargojet 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 Cargojet’s equity capital deployed. Its cost of equity is 11.68%. This means Cargojet returns enough to cover its own cost of equity, with a buffer of 4.82%. This sustainable practice implies that the company pays less for its capital than what it generates 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
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 Cargojet’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 Cargojet’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 Cargojet’s debt-to-equity ratio. The ratio currently stands is significantly high, above 2.5 times, meaning Cargojet has taken on a disproportionately large level of debt which is driving the high return. The company’s ability to produce profit growth hinges on its large debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Cargojet exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Cargojet’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Cargojet, there are three pertinent aspects 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 Cargojet 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 Cargojet is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Cargojet? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.