Trifast plc (LSE:TRI) delivered an ROE of 13.69% over the past 12 months, which is an impressive feat relative to its industry average of 10.93% during the same period. While the impressive ratio tells us that TRI has made significant profits from little equity capital, ROE doesn’t tell us if TRI has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether TRI’s ROE is actually sustainable. View our latest analysis for Trifast
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of TRI’s profit relative to its shareholders’ equity. For example, if TRI invests £1 in the form of equity, it will generate £0.14 in earnings from this. 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
Returns are usually compared to costs to measure the efficiency of capital. TRI’s cost of equity is 8.30%. Given a positive discrepancy of 5.40% between return and cost, this indicates that TRI 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. The other component, asset turnover, illustrates how much revenue TRI can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check TRI’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 30.57%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? TRI’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. 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 TRI, 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 Trifast 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.