This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Treatt plc (LON:TET) delivered an ROE of 15.43% over the past 12 months, which is relatively in-line with its industry average of 15.74% during the same period. But what is more interesting is whether TET can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of TET’s returns.
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Treatt’s profit relative to its shareholders’ equity. An ROE of 15.43% implies £0.15 returned on every £1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Specialty Chemicals sector by investing in 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 Treatt, which is 8.28%. Some of Treatt’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for Treatt which is reassuring. ROE can be broken down into three different 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 Treatt can generate with its current 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 assess whether Treatt is fuelling ROE by excessively raising debt. Ideally, Treatt should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently the ratio stands at 2.87%, which is very low. This means Treatt has not taken on leverage, which could explain its below-average ROE. Treatt still has headroom to take on more leverage in order to grow its returns.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Even though Treatt returned below the industry average, its ROE comes in excess of its cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of Treatt’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 Treatt, I’ve compiled three key factors 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.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for Treatt’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Treatt? 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.