With an ROE of 15.21%, Inter Pipeline Ltd (TSX:IPL) outpaced its own industry which delivered a less exciting 5.96% over the past year. On the surface, this looks fantastic since we know that IPL has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of IPL’s ROE. View our latest analysis for Inter Pipeline
Breaking down Return on Equity
Return on Equity (ROE) weighs Inter Pipeline’s profit against the level of its shareholders’ equity. An ROE of 15.21% implies CA$0.15 returned on every CA$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 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 Inter Pipeline, which is 13.67%. Since Inter Pipeline’s return covers its cost in excess of 1.54%, its use of equity capital is efficient and likely to be sustainable. Simply put, Inter Pipeline pays less 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:
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 Inter Pipeline’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 financial leverage can artificially inflate ROE, we need to look at how much debt Inter Pipeline currently has. The debt-to-equity ratio currently stands at a high 156.92%, meaning the above-average ratio is a result of a large amount of debt.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Inter Pipeline exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Inter Pipeline’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.