With an ROE of 13.44%, Jewett-Cameron Trading Company Ltd (NASDAQ:JCTC.F) outpaced its own industry which delivered a less exciting 12.85% over the past year. Superficially, this looks great since we know that JCTC.F has generated big profits with little equity capital; however, ROE doesn’t tell us how much JCTC.F has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of JCTC.F’s ROE. View our latest analysis for Jewett-Cameron Trading
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Jewett-Cameron Trading’s cost of equity is 8.49%. This means Jewett-Cameron Trading returns enough to cover its own cost of equity, with a buffer of 4.95%. This sustainable practice implies that the company 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
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 Jewett-Cameron Trading 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 Jewett-Cameron Trading’s debt-to-equity level. Currently, Jewett-Cameron Trading 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. Jewett-Cameron Trading 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.