With an ROE of 14.56%, Tile Shop Holdings Inc (NASDAQ:TTS) outpaced its own industry which delivered a less exciting 13.12% over the past year. While the impressive ratio tells us that TTS has made significant profits from little equity capital, ROE doesn’t tell us if TTS has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of TTS’s ROE. View our latest analysis for Tile Shop Holdings
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of TTS’s profit relative to its shareholders’ equity. For example, if TTS invests $1 in the form of equity, it will generate $0.15 in earnings from this. 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
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 TTS, which is 9.53%. Given a positive discrepancy of 5.04% between return and cost, this indicates that TTS pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue TTS 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 TTS’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt TTS currently has. At 12.90%, TTS’s debt-to-equity ratio appears low 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? TTS’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis.