Tamawood Limited (ASX:TWD) outperformed the Homebuilding industry on the basis of its ROE – producing a higher 70.54% relative to the peer average of 22.93% over the past 12 months. While the impressive ratio tells us that TWD has made significant profits from little equity capital, ROE doesn’t tell us if TWD has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable TWD’s ROE is. See our latest analysis for Tamawood

Breaking down ROE — the mother of all ratios

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 70.54% implies A$0.71 returned on every A$1 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

ROE is measured against cost of equity in order to determine the efficiency of Tamawood’s equity capital deployed. Its cost of equity is 8.55%. Since Tamawood’s return covers its cost in excess of 61.99%, its use of equity capital is efficient and likely to be sustainable. Simply put, Tamawood 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 shows how much revenue Tamawood 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 inflated by excessive debt, we need to examine Tamawood’s debt-to-equity level. Currently, Tamawood 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. Tamawood’s above-industry ROE is encouraging, and is also in excess of 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.