Is Redde plc’s (AIM:REDD) 16.80% ROE Good Enough Compared To Its Industry?
Redde plc (AIM:REDD) outperformed the Trucking industry on the basis of its ROE – producing a higher 16.80% relative to the peer average of 12.11% over the past 12 months. On the surface, this looks fantastic since we know that REDD has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether REDD’s ROE is actually sustainable. View our latest analysis for Redde
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of REDD’s profit relative to its shareholders’ equity. For example, if REDD invests £1 in the form of equity, it will generate £0.17 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. REDD’s cost of equity is 8.30%. This means REDD returns enough to cover its own cost of equity, with a buffer of 8.50%. 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:
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 REDD’s 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 REDD’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check REDD’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 28.98%, 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? REDD exhibits a strong ROE against its peers, as well as sufficient returns to cover 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 REDD, 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 Redde 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.
