Allegiant Travel Company (NASDAQ:ALGT) outperformed the Airlines industry on the basis of its ROE – producing a higher 33.56% relative to the peer average of 19.42% over the past 12 months. Superficially, this looks great since we know that ALGT has generated big profits with little equity capital; however, ROE doesn’t tell us how much ALGT has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether ALGT’s ROE is actually sustainable. Check out our latest analysis for Allegiant Travel
Peeling the layers of ROE – trisecting a company’s profitability
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 $1 in the form of equity, it will generate $0.34 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 Allegiant Travel, which is 8.49%. This means Allegiant Travel returns enough to cover its own cost of equity, with a buffer of 25.06%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be dissected into three distinct 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. Asset turnover reveals how much revenue can be generated from Allegiant Travel’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 the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Allegiant Travel currently has. Currently the debt-to-equity ratio stands at a high 213.49%, which means its above-average ROE is driven by significant debt levels.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Allegiant Travel’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Allegiant Travel’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Allegiant Travel, I’ve compiled three essential factors you should further research:
- 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 Allegiant Travel 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 Allegiant Travel is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Allegiant Travel? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.