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Bharat Heavy Electricals Limited (NSEI:BHEL) delivered a less impressive 1.36% ROE over the past year, compared to the 10.79% return generated by its industry. Though BHEL’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on BHEL’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of BHEL’s returns. See our latest analysis for Bharat Heavy Electricals
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.01 in earnings from this. 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 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 Bharat Heavy Electricals, which is 15.11%. This means Bharat Heavy Electricals’s returns actually do not cover its own cost of equity, with a discrepancy of -13.75%. 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 split up into three useful 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 reveals how much revenue can be generated from Bharat Heavy Electricals’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Bharat Heavy Electricals’s historic debt-to-equity ratio. Currently Bharat Heavy Electricals has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why Bharat Heavy Electricals’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.