Will Toyota Caetano Portugal SA. (ELI:SCT) Continue To Underperform Its Industry?

Toyota Caetano Portugal SA. (ENXTLS:SCT) delivered a less impressive 7.16% ROE over the past year, compared to the 15.22% return generated by its industry. SCT's results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on SCT’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of SCT's returns. Check out our latest analysis for Toyota Caetano Portugal

What you must know about ROE

Return on Equity (ROE) weighs Toyota Caetano Portugal’s profit against the level of its shareholders’ equity. An ROE of 7.16% implies €0.07 returned on every €1 invested, so the higher the return, the better. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Automobile Manufacturers 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 Toyota Caetano Portugal has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.

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 Toyota Caetano Portugal, which is 10.52%. Since Toyota Caetano Portugal’s return does not cover its cost, with a difference of -3.36%, this means its current use of equity is not efficient and not sustainable. Very simply, Toyota Caetano Portugal pays more for its capital than what it generates in return. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

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 Toyota Caetano Portugal 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 Toyota Caetano Portugal is fuelling ROE by excessively raising debt. Ideally, Toyota Caetano Portugal should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The most recent ratio is 54.95%, which is sensible and indicates Toyota Caetano Portugal has not taken on too much leverage. Thus, we can conclude its current ROE is generated from its capacity to increase profit without a large debt burden.

Next Steps:

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. Toyota Caetano Portugal’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.

For Toyota Caetano Portugal, I've compiled three key factors you should look at:

• 1. 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.
• 2. Valuation: What is Toyota Caetano Portugal 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 Toyota Caetano Portugal is currently mispriced by the market.
• 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Toyota Caetano Portugal? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.