The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning the link between TC PipeLines LP (NYSE:TCP)’s return fundamentals and stock market performance.
TC PipeLines LP (NYSE:TCP) outperformed the oil and gas storage and transportation industry on the basis of its ROE – producing a higher 25.09% relative to the peer average of 11.31% over the past 12 months. However, whether this above-industry ROE is actually impressive depends on if it can be maintained. A measure of sustainable returns is TCP’s financial leverage. If TCP 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. View out our latest analysis for TC PipeLines
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 25.09% implies $0.25 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 Oil and Gas Storage and Transportation sector by investing in 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 TC PipeLines has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. TC PipeLines’s cost of equity is 14.23%. Since TC PipeLines’s return covers its cost in excess of 10.86%, its use of equity capital is efficient and likely to be sustainable. Simply put, TC PipeLines pays less for its capital than what it generates in return. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from TC PipeLines’s 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 TC PipeLines is fuelling ROE by excessively raising debt. Ideally, TC PipeLines should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands at a high 211.48%, meaning TC PipeLines may have taken on a disproportionate level of debt which is driving the high return. The company’s ability to produce profit growth may hinge on its big debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. TC PipeLines’s above-industry ROE is encouraging, and is also in excess of its cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For TC PipeLines, I’ve compiled three fundamental 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.
- Valuation: What is TC PipeLines 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 TC PipeLines is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of TC PipeLines? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!