Arvind SmartSpaces Limited (NSEI:ARVSMART) outperformed the Real Estate Development industry on the basis of its ROE – producing a higher 13.18% relative to the peer average of 4.64% over the past 12 months. While the impressive ratio tells us that ARVSMART has made significant profits from little equity capital, ROE doesn’t tell us if ARVSMART has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of ARVSMART’s ROE. Check out our latest analysis for Arvind SmartSpaces
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Arvind SmartSpaces’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Arvind SmartSpaces’s equity capital deployed. Its cost of equity is 14.43%. Since Arvind SmartSpaces’s return does not cover its cost, with a difference of -1.25%, this means its current use of equity is not efficient and not sustainable. Very simply, Arvind SmartSpaces pays more for its capital than what it generates in return. ROE can be broken down into three different 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
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 Arvind SmartSpaces 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. Since financial leverage can artificially inflate ROE, we need to look at how much debt Arvind SmartSpaces currently has. At 59.65%, Arvind SmartSpaces’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Arvind SmartSpaces exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. 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. Although ROE can be a useful metric, it is only a small part of diligent research.