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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 begin learning the link between company’s fundamentals and stock market performance.
NLC India Limited (NSE:NLCINDIA) outperformed the Independent Power Producers and Energy Traders industry on the basis of its ROE – producing a higher 13.9% relative to the peer average of 5.4% over the past 12 months. While the impressive ratio tells us that NLCINDIA has made significant profits from little equity capital, ROE doesn’t tell us if NLCINDIA has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether NLCINDIA’s ROE is actually sustainable.
Check out our latest analysis for NLC India
What you must know about ROE
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 ₹0.14 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making 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 NLC India, which is 13.5%. Given a positive discrepancy of 0.4% between return and cost, this indicates that NLC India pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 reveals how much revenue can be generated from NLC India’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 NLC India’s historic debt-to-equity ratio. At 94.1%, NLC India’s debt-to-equity ratio appears balanced and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.