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 company’s fundamentals and stock market performance.
PAM Transportation Services Inc (NASDAQ:PTSI) delivered an ROE of 33.7% over the past 12 months, which is an impressive feat relative to its industry average of 19.2% during the same period. Superficially, this looks great since we know that PTSI has generated big profits with little equity capital; however, ROE doesn’t tell us how much PTSI has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable PTSI’s ROE is.
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 P.A.M. Transportation Services’s equity capital deployed. Its cost of equity is 12.2%. This means P.A.M. Transportation Services returns enough to cover its own cost of equity, with a buffer of 21.5%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be broken down into three different 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue P.A.M. Transportation Services 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 P.A.M. Transportation Services’s debt-to-equity level. At 160%, P.A.M. Transportation Services’s debt-to-equity ratio appears relatively high and indicates the above-average ROE is generated by significant leverage levels.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. P.A.M. Transportation Services’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 P.A.M. Transportation Services, I’ve compiled 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.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for P.A.M. Transportation Services’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of P.A.M. Transportation Services? 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 past 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. For errors that warrant correction please contact the editor at firstname.lastname@example.org.