Equitas Holdings Limited’s (NSEI:EQUITAS) most recent return on equity was a substandard 0.15% relative to its industry performance of 7.42% over the past year. Though EQUITAS’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 EQUITAS’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of EQUITAS’s returns. Check out our latest analysis for Equitas Holdings
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. For example, if the company invests ₹1 in the form of equity, it will generate ₹0 in earnings from this. 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 Equitas Holdings’s equity capital deployed. Its cost of equity is 13.40%. This means Equitas Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -13.25%. 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 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Equitas Holdings can generate with its current 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 Equitas Holdings currently has. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its below-average ROE is already being driven by significant debt levels.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Equitas Holdings’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Equitas Holdings’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.