In This Article:
I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
BASF India Limited (NSE:BASF) delivered an ROE of 20.1% over the past 12 months, which is an impressive feat relative to its industry average of 13.1% during the same period. On the surface, this looks fantastic since we know that BASF has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable BASF’s ROE is.
View our latest analysis for BASF India
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs BASF India’s profit against the level of its shareholders’ equity. An ROE of 20.1% implies ₹0.20 returned on every ₹1 invested. 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 BASF India, which is 13.5%. Since BASF India’s return covers its cost in excess of 6.6%, its use of equity capital is efficient and likely to be sustainable. Simply put, BASF India 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:
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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue BASF India can generate with its current 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 ROE can be artificially increased through excessive borrowing, we should check BASF India’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 64.6%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. BASF India’s above-industry ROE is encouraging, and is also in excess of its cost of equity. 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.