What is Behind ATCO Ltd’s (TSE:ACO.X) Superior ROE?
ATCO Ltd (TSX:ACO.X) outperformed the Multi-Utilities industry on the basis of its ROE – producing a higher 8.59% relative to the peer average of 6.95% over the past 12 months. While the impressive ratio tells us that ACO.X has made significant profits from little equity capital, ROE doesn’t tell us if ACO.X has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable ACO.X’s ROE is. View our latest analysis for ATCO
What you must know about ROE
Return on Equity (ROE) is a measure of ATCO’s profit relative to its shareholders’ equity. For example, if the company invests CA$1 in the form of equity, it will generate CA$0.09 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. ATCO’s cost of equity is 11.69%. This means ATCO’s returns actually do not cover its own cost of equity, with a discrepancy of -3.10%. 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 dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
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. The other component, asset turnover, illustrates how much revenue ATCO 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. Since ROE can be inflated by excessive debt, we need to examine ATCO’s debt-to-equity level. At 121.65%, ATCO’s debt-to-equity ratio appears balanced and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? ACO.X exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means ACO.X still has room to improve shareholder returns by raising debt to fund new investments. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If you are considering investing in ACO.X, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on ATCO to help you make a more informed investment decision.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.
