With an ROE of 38.89%, Tekcapital plc (AIM:TEK) outpaced its own industry which delivered a less exciting 19.08% over the past year. Though, the impressiveness of TEK’s ROE is contingent on whether this industry-beating level can be sustained. This can be measured by looking at the company’s financial leverage. With more debt, TEK can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further. See our latest analysis for Tekcapital
Breaking down Return on Equity
Return on Equity (ROE) weighs Tekcapital’s profit against the level of its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.39 in earnings from this. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Research and Consulting Services 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 Tekcapital, which is 8.30%. Since Tekcapital’s return covers its cost in excess of 30.59%, its use of equity capital is efficient and likely to be sustainable. Simply put, Tekcapital 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Tekcapital’s 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 Tekcapital is fuelling ROE by excessively raising debt. Ideally, Tekcapital should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently, Tekcapital has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Tekcapital’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.
For Tekcapital, there are three essential 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 Tekcapital 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 Tekcapital is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Tekcapital? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!