This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between company’s fundamentals and stock market performance.
The Colonial Motor Company Limited (NZSE:CMO) performed in line with its automotive retail industry on the basis of its ROE – producing a return of 13.6% relative to the peer average of 15.0% over the past 12 months. But what is more interesting is whether CMO 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 CMO’s returns. Let me show you what I mean by this.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Colonial Motor’s profit relative to its shareholders’ equity. For example, if the company invests NZ$1 in the form of equity, it will generate NZ$0.14 in earnings from this. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Automotive Retail 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
Returns are usually compared to costs to measure the efficiency of capital. Colonial Motor’s cost of equity is 9.0%. Colonial Motor’s ROE exceeds its cost by 4.6%, 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 Colonial Motor’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. The other component, asset turnover, illustrates how much revenue Colonial Motor can make from its 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 Colonial Motor is fuelling ROE by excessively raising debt. Ideally, Colonial Motor 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 65.2%, which is reasonable. This means Colonial Motor 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.
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. Although Colonial Motor’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 Colonial Motor’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 Colonial Motor, I’ve compiled three relevant 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.
- Future Earnings: How does Colonial Motor’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 Colonial Motor? 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 email@example.com.