I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Technical Publications Service SpA (BIT:TPS) outperformed the Research and Consulting Services industry on the basis of its ROE – producing a higher 26.3% relative to the peer average of 12.7% over the past 12 months. While the impressive ratio tells us that TPS has made significant profits from little equity capital, ROE doesn’t tell us if TPS has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of TPS’s ROE.
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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. An ROE of 26.3% implies €0.26 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
Returns are usually compared to costs to measure the efficiency of capital. Technical Publications Service’s cost of equity is 8.4%. This means Technical Publications Service returns enough to cover its own cost of equity, with a buffer of 18.0%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be split up into three useful 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. The other component, asset turnover, illustrates how much revenue Technical Publications Service can make from its 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 the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Technical Publications Service’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 16.4%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.