This article is intended for those of you who are at the beginning of your investing journey and want to better understand how you can grow your money by investing in ATA Inc (NASDAQ:ATAI).
With an ROE of 16.80%, ATA Inc (NASDAQ:ATAI) outpaced its own industry which delivered a less exciting 12.94% over the past year. Though, the impressiveness of ATAI’s ROE is contingent on whether this industry-beating level can be sustained. A measure of sustainable returns is ATAI’s financial leverage. If ATAI borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface. See our latest analysis for ATA
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of ATA’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Education 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
Returns are usually compared to costs to measure the efficiency of capital. ATA’s cost of equity is 8.87%. Given a positive discrepancy of 7.93% between return and cost, this indicates that ATA pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 shows how much revenue ATA can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether ATA is fuelling ROE by excessively raising debt. Ideally, ATA should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently, ATA 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.
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. ATA’s ROE is impressive relative to the industry average and also covers its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For ATA, I’ve put together three important 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.
- Valuation: What is ATA 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 ATA is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of ATA? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!