With an ROE of 25.09%, TC PipeLines LP (NYSE:TCP) outpaced its own industry which delivered a less exciting 11.31% over the past year. But what is more interesting is whether TCP can sustain this above-average ratio. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this. View 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
ROE is measured against cost of equity in order to determine the efficiency of TC PipeLines’s equity capital deployed. Its cost of equity is 15.34%. Given a positive discrepancy of 9.75% between return and cost, this indicates that TC PipeLines 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
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. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at TC PipeLines’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 211.48%, which is relatively high, indicating TC PipeLines’s above-average ROE is generated by its high leverage and its ability to grow profit hinges on a sizeable debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. TC PipeLines exhibits a strong ROE against its peers, as well as sufficient returns to cover 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 put together three key 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 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!