With an ROE of 7.02%, Public Joint Stock Company Territorial Generation Company No 14 (MISX:TGKN) returned in-line to its own industry which delivered 9.31% over the past year. But what is more interesting is whether TGKN 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 TGKN’s returns. See our latest analysis for Territorial Generation Company No. 14
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Electric Utilities industry may want to choose the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Territorial Generation Company No. 14’s equity capital deployed. Its cost of equity is 13.41%. This means Territorial Generation Company No. 14’s returns actually do not cover its own cost of equity, with a discrepancy of -6.39%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. 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
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 Territorial Generation Company No. 14 can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if Territorial Generation Company No. 14’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 Territorial Generation Company No. 14’s debt-to-equity ratio. The most recent ratio is 66.28%, which is sensible and indicates Territorial Generation Company No. 14 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.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Territorial Generation Company No. 14 exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Territorial Generation Company No. 14’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 Territorial Generation Company No. 14, I’ve compiled three essential aspects 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.
- Future Earnings: How does Territorial Generation Company No. 14’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 Territorial Generation Company No. 14? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!