Cambridge Technology Enterprises Limited (NSEI:CTE) delivered an ROE of 31.38% over the past 12 months, which is an impressive feat relative to its industry average of 14.72% during the same period. But what is more interesting is whether CTE can sustain this above-average ratio. A measure of sustainable returns is CTE’s financial leverage. If CTE borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface.
Breaking down Return on Equity
Return on Equity (ROE) weighs Cambridge Technology Enterprises’s profit against the level of its shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.31 in earnings from this. Investors seeking to maximise their return in the IT Consulting and Other Services industry may want to choose the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt Cambridge Technology Enterprises has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Cambridge Technology Enterprises’s equity capital deployed. Its cost of equity is 13.40%. Given a positive discrepancy of 17.98% between return and cost, this indicates that Cambridge Technology Enterprises pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be broken down into three different ratios: net profit margin, asset turnover, and financial leverage. This is called the 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 Cambridge Technology Enterprises can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. We can determine if Cambridge Technology Enterprises’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Cambridge Technology Enterprises’s debt-to-equity ratio. The ratio currently stands at a sensible 29.55%, meaning Cambridge Technology Enterprises has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Cambridge Technology Enterprises’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Cambridge Technology Enterprises, there are three pertinent aspects you should look at:
1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Valuation: What is Cambridge Technology Enterprises worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Cambridge Technology Enterprises is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Cambridge Technology Enterprises? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
This article is originally published in simplywall.st.