Did Canadian Pacific Railway Limited (TSE:CP) Create Value For Shareholders?
Canadian Pacific Railway Limited (TSX:CP) delivered an ROE of 36.09% over the past 12 months, which is an impressive feat relative to its industry average of 11.18% during the same period. While the impressive ratio tells us that CP has made significant profits from little equity capital, ROE doesn’t tell us if CP has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of CP’s ROE. See our latest analysis for Canadian Pacific Railway
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Canadian Pacific Railway’s profit against the level of its shareholders’ equity. An ROE of 36.09% implies CA$0.36 returned on every CA$1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Canadian Pacific Railway’s equity capital deployed. Its cost of equity is 9.85%. This means Canadian Pacific Railway returns enough to cover its own cost of equity, with a buffer of 26.24%. This sustainable practice implies that the company 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:
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 Canadian Pacific Railway can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Canadian Pacific Railway’s debt-to-equity level. Currently the debt-to-equity ratio stands at a balanced 130.45%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Canadian Pacific Railway exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Canadian Pacific Railway, there are three essential factors you should look at:
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 Canadian Pacific Railway 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 Canadian Pacific Railway is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Canadian Pacific Railway? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
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.
