Trention AB (publ) (OM:TRENT) delivered an ROE of 11.67% over the past 12 months, which is an impressive feat relative to its industry average of 6.96% during the same period. Superficially, this looks great since we know that TRENT has generated big profits with little equity capital; however, ROE doesn’t tell us how much TRENT has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of TRENT’s ROE. See our latest analysis for Trention
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Trention’s profit relative to its shareholders’ equity. An ROE of 11.67% implies SEK0.12 returned on every SEK1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. Trention’s cost of equity is 8.17%. This means Trention returns enough to cover its own cost of equity, with a buffer of 3.51%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be dissected into three distinct 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Trention’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 the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Trention’s historic debt-to-equity ratio. Currently, Trention has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
Next Steps:
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. Trention exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.