Based on its ROE, is Canadian Tire Corporation, Limited (TSE:CTC.A) a high quality stock?
Many investors are still learning the different metrics that can be useful when analyzing a stock. This article is for those who want to know more about return on equity (ROE). As part of a learning-by-doing, we will examine ROE to better understand Canadian Tire Corporation, Limited (TSE: CTC.A).
Return on equity or ROE is a key metric used to gauge how effectively a company’s management is using the company’s capital. In simpler terms, it measures a company’s profitability relative to equity.
Check out our latest analysis for Canadian Tire Corporation
How to calculate return on equity?
Return on equity can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, according to the formula above, the ROE of Canadian Tire Corporation is:
20% = C$1.3 billion ÷ C$6.6 billion (based on trailing 12 months to April 2022).
“Yield” refers to a company’s earnings over the past year. This means that for every Canadian dollar of equity, the company generated a profit of 0.20 Canadian dollars.
Does Canadian Tire Corporation have a good ROE?
By comparing a company’s ROE with the average for its industry, we can get a quick measure of its quality. The limitation of this approach is that some companies are very different from others, even within the same industrial classification. As shown in the chart below, Canadian Tire Corporation has a below average ROE (26%) in the Multiline Retail industry classification.
That’s not what we like to see. However, a low ROE is not always bad. If the company’s debt levels are moderate to low, there is always a chance that returns can be enhanced through the use of leverage. When a company has a low ROE but a high level of debt, we would be cautious because the risk involved is too high.
Why You Should Consider Debt When Looking at ROE
Virtually all businesses need money to invest in the business, to increase their profits. The money for the investment can come from the previous year’s earnings (retained earnings), from issuing new shares or from borrowing. In the first and second case, the ROE will reflect this use of cash for investment in the business. In the latter case, debt used for growth will improve returns, but will not affect total equity. Thus, the use of debt can improve ROE, but with an additional risk in the event of a storm, metaphorically speaking.
Canadian Tire Corporation’s debt and its 20% ROE
Of note is the high reliance on debt by Canadian Tire Corporation, resulting in a leverage ratio of 1.26. Although its ROE is quite respectable, the amount of debt the company is currently carrying is not ideal. Debt brings additional risk, so it’s only really worth it when a business is generating decent returns.
Return on equity is useful for comparing the quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have roughly the same level of debt and one has a higher ROE, I generally prefer the one with a higher ROE.
But when a company is of high quality, the market often gives it a price that reflects that. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. So I think it’s worth checking it out free analyst forecast report for the company.
But note: Canadian Tire Corporation may not be the best stock to buy. So take a look at this free list of interesting companies with high ROE and low debt.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.