Cabcharge Australia Limited (ASX:CAB) delivered a less impressive 4.82% ROE over the past year, compared to the 9.05% return generated by its industry. 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 CAB’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of CAB’s returns. Let me show you what I mean by this. View our latest analysis for Cabcharge Australia
What you must know about ROE
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 CAB can generate in earnings given the amount of equity it has raised. 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
Returns are usually compared to costs to measure the efficiency of capital. CAB’s cost of equity is 8.55%. Given a discrepancy of -3.73% between return and cost, this indicated that CAB may be paying more for its capital than what it’s generating 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 reveals how much revenue can be generated from CAB’s 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 CAB’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt CAB currently has. The debt-to-equity ratio currently stands at a low 2.03%, meaning CAB still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? CAB exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as CAB still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.