With an ROE of 11.14%, Technopolis Plc (HLSE:TPS1V) outpaced its own industry which delivered a less exciting 9.95% over the past year. Superficially, this looks great since we know that TPS1V has generated big profits with little equity capital; however, ROE doesn’t tell us how much TPS1V has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether TPS1V’s ROE is actually sustainable. View our latest analysis for Technopolis
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Technopolis’s profit against the level of its shareholders’ equity. An ROE of 11.14% implies €0.11 returned on every €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 Technopolis’s equity capital deployed. Its cost of equity is 13.62%. This means Technopolis’s returns actually do not cover its own cost of equity, with a discrepancy of -2.47%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be split up into three useful 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 Technopolis’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 Technopolis’s debt-to-equity level. Currently the debt-to-equity ratio stands at a balanced 102.81%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Technopolis exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.