Turquoise Hill Resources Ltd (TSX:TRQ) delivered a less impressive 2.07% ROE over the past year, compared to the 7.18% return generated by its industry. TRQ’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on TRQ’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of TRQ’s returns. Check out our latest analysis for Turquoise Hill Resources
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Turquoise Hill Resources’s profit relative to its shareholders’ equity. An ROE of 2.07% implies CA$0.02 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 Turquoise Hill Resources’s equity capital deployed. Its cost of equity is 17.87%. Since Turquoise Hill Resources’s return does not cover its cost, with a difference of -15.80%, this means its current use of equity is not efficient and not sustainable. Very simply, Turquoise Hill Resources 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 shows how much revenue Turquoise Hill Resources can generate with its current 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 artificially increased through excessive borrowing, we should check Turquoise Hill Resources’s historic debt-to-equity ratio. At 52.01%, Turquoise Hill Resources’s debt-to-equity ratio appears sensible and indicates its ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? TRQ exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means TRQ still has room to improve shareholder returns by raising debt to fund new investments. 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 TRQ, 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 Turquoise Hill Resources 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.