Rocky Mountain Dealerships Inc (TSX:RME) delivered an ROE of 11.44% over the past 12 months, which is an impressive feat relative to its industry average of 10.89% during the same period. While the impressive ratio tells us that RME has made significant profits from little equity capital, ROE doesn’t tell us if RME has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether RME’s ROE is actually sustainable. View our latest analysis for Rocky Mountain Dealerships
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Rocky Mountain Dealerships’s profit relative to its shareholders’ equity. For example, if the company invests CA$1 in the form of equity, it will generate CA$0.11 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Rocky Mountain Dealerships, which is 17.86%. Since Rocky Mountain Dealerships’s return does not cover its cost, with a difference of -6.42%, this means its current use of equity is not efficient and not sustainable. Very simply, Rocky Mountain Dealerships pays more 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. Asset turnover reveals how much revenue can be generated from Rocky Mountain Dealerships’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Rocky Mountain Dealerships’s debt-to-equity level. The debt-to-equity ratio currently stands at a high 171.85%, meaning the above-average ratio is a result of a large amount of debt.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Rocky Mountain Dealerships’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. Its debt level is above equity which means its above-industry ROE may be driven by debt funding which raises concerns over the sustainability of Rocky Mountain Dealerships’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Rocky Mountain Dealerships, I’ve compiled three key aspects you should further research:
- 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 Rocky Mountain Dealerships 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 Rocky Mountain Dealerships is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Rocky Mountain Dealerships? 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.