Port of Tauranga Limited (NZSE:POT) generated a below-average return on equity of 9.82% in the past 12 months, while its industry returned 11.26%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into POT’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of POT’s returns. Check out our latest analysis for Port of Tauranga

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) is a measure of Port of Tauranga’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 Port of Tauranga’s equity capital deployed. Its cost of equity is 9.01%. Some of Port of Tauranga’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for Port of Tauranga which is reassuring. 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 shows how much revenue Port of Tauranga can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Port of Tauranga’s debt-to-equity level. At 47.70%, Port of Tauranga’s debt-to-equity ratio appears low and indicates that Port of Tauranga still has room to increase leverage and grow its profits.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Even though Port of Tauranga returned below the industry average, its ROE comes in excess of its cost of equity. Also, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.