This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Banka BioLoo Limited (NSE:BANKA) delivered an ROE of 10.6% over the past 12 months, which is an impressive feat relative to its industry average of 8.8% during the same period. While the impressive ratio tells us that BANKA has made significant profits from little equity capital, ROE doesn’t tell us if BANKA has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether BANKA’s ROE is actually sustainable.
Check out our latest analysis for Banka BioLoo
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. 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 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 Banka BioLoo, which is 13.5%. This means Banka BioLoo’s returns actually do not cover its own cost of equity, with a discrepancy of -2.9%. This isn’t sustainable as it implies, very simply, that the company pays more 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:
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 shows how much revenue Banka BioLoo can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Banka BioLoo’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 23.9%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.