The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about Return on Equity using a real-life example.
With an ROE of 6.4%, Navkar Corporation Limited (NSE:NAVKARCORP) outpaced its own industry which delivered a less exciting 3.6% over the past year. On the surface, this looks fantastic since we know that NAVKARCORP has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of NAVKARCORP’s ROE.
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Breaking down Return on Equity
Return on Equity (ROE) weighs Navkar’s profit against the level of its shareholders’ equity. An ROE of 6.4% implies ₹0.064 returned on every ₹1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Navkar’s equity capital deployed. Its cost of equity is 15.9%. Given a discrepancy of -9.4% between return and cost, this indicated that Navkar may be paying more for its capital than what it’s generating 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 Navkar 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 inflated by excessive debt, we need to examine Navkar’s debt-to-equity level. At 23.8%, Navkar’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Navkar exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of industry-beating returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.