With an ROE of 12.26%, Collins Foods Limited (ASX:CKF) outpaced its own industry which delivered a less exciting 11.89% over the past year. On the surface, this looks fantastic since we know that CKF has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether CKF’s ROE is actually sustainable. View our latest analysis for Collins Foods
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of CKF’s profit relative to its shareholders’ equity. An ROE of 12.26% implies $0.12 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 CKF’s equity capital deployed. Its cost of equity is 8.55%. Since CKF’s return covers its cost in excess of 3.71%, its use of equity capital is efficient and likely to be sustainable. Simply put, CKF 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
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 CKF can generate with its current 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 CKF’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine CKF’s debt-to-equity level. At 69.90%, CKF’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? CKF’s ROE is impressive relative to the industry average and also covers its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of CKF to your portfolio if your personal research is confirming what the ROE is telling you.
Are you a potential investor? If you are considering investing in CKF, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Collins Foods to help you make a more informed investment decision. If you are not interested in CKF anymore, you can use our free platform to see our list of stocks with Return on Equity over 20%.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.