In This Article:
Tegel Group Holdings Limited (NZSE:TGH) delivered a less impressive 7.01% ROE over the past year, compared to the 14.32% return generated by its industry. Though TGH’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on TGH’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of TGH’s returns. Let me show you what I mean by this. View our latest analysis for Tegel Group Holdings
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. For example, if the company invests NZ$1 in the form of equity, it will generate NZ$0.07 in earnings from this. 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
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Tegel Group Holdings, which is 8.55%. This means Tegel Group Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -1.54%. This isn’t sustainable as it implies, very simply, that the company pays more 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 Tegel Group Holdings 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 financial leverage can artificially inflate ROE, we need to look at how much debt Tegel Group Holdings currently has. At 30.93%, Tegel Group Holdings’s debt-to-equity ratio appears low and indicates that Tegel Group Holdings still has room to increase leverage and grow its profits.