Should I buy the UK’s most ‘profitable’ penny stock? Not so fast…
Compared to established FTSE names, penny stocks are often considered riskier investments. One reason for this is the inherent difficulty in assessing their value.
One example is Topps Tiles (LSE: TPT). Despite an eye-wateringly high return on equity (ROE) and a chunky 8.9% yield, it appears to be drowning in debt. Why?
Let’s take a look
On closer inspection, Topps Tiles may not be as profitable as first appears. But that’s not to say it isn’t performing well.
Latest full-year results show adjusted sales up 6.8% to £295.8m, profit before tax 46% ahead to £9.2m, and a proposed full-year dividend up 20.8% to 2.9p a share.
Plus, the market still values it cheaply, with a share price around 35p and a forward price-to-earnings (P/E) ratio just above 8. However, that cheap rating reflects a business tied to a soft UK home improvement market.
Why the ROE looks so high
When it comes to penny stocks, ROE can look unusually strong due to a small equity base. For Topps, this is the case due to years of lease-heavy retail operations, acquisitions, and IFRS 16 accounting practices.
Basically, it uses a lease model rather than ownship, and those lease liabilities make the balance sheet look more debt-heavy than a typical retailer.
The company also points out that its âadjusted net cashâ excludes lease liabilities, while statutory measures include them. This is critical, as the figures can look very different depending on which version you use.
Why the dividend stays high
With a capital-friendly policy, Toppsâ shareholder base has come to appreciate the rising payout. Subsequently, it has kept the dividend moving higher even through rough patches. That means, at times, the dividend may lack strong cash coverage.
In 2025, operating cash flow was recorded as around £18m. But when you factor in maintenance and growth capex, lease repayments and acquisitions, itâs closer to £2.6m. With £3.9m of dividends paid, thatâs a bit tight on a strict cash basis.
This is key for income investors. While a dividend may be supported by the business model and balance sheet, itâs not always covered comfortably by cash.
True borrowings matter
Debt’s where things can get tricky, especially for penny stocks. Topps had only £11m of bank borrowings at year-end, but lease liabilities were £99.8m. So most of its total debt’s really the cost of operating stores â not bank borrowing in the usual sense.
It also had a £30m loan facility and £7.4m of net cash before IFRS 16 lease liabilities, which suggests bank debt costs are manageable for now.
Still, that doesnât make it risk free. Besides the volatility risks that small-caps face, weak consumer confidence and higher operating costs add pressure. If the housing and renovation market stays soft for longer than expected, that could threaten profits â and the dividend.
The bottom line
This example shows why taking headline numbers at face value can often be misleading, and even more so for micro-caps.
But donât get me wrong â Topps Tiles is probably one of the safer penny stocks on the UK market today. Debt looks manageable, recent results are strong, and the high yield makes it worth considering for income.
Confident that the home improvement market will recover, I aim to buy a small allocation of the shares in the coming months, once the current market correction has run its course.
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Mark Hartley has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
