Oil and Natural Gas Corporation Limited’s (NSEI:ONGC) most recent return on equity was a substandard 10.09% relative to its industry performance of 23.22% over the past year. Though ONGC’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 ONGC’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of ONGC’s returns. Check out our latest analysis for Oil and Natural Gas

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) weighs Oil and Natural Gas’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 measured against cost of equity in order to determine the efficiency of Oil and Natural Gas’s equity capital deployed. Its cost of equity is 13.40%. Since Oil and Natural Gas’s return does not cover its cost, with a difference of -3.31%, this means its current use of equity is not efficient and not sustainable. Very simply, Oil and Natural Gas 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

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 Oil and Natural Gas’s 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 Oil and Natural Gas currently has. At 25.93%, Oil and Natural Gas’s debt-to-equity ratio appears low and indicates that Oil and Natural Gas still has room to increase leverage and grow its profits.

What this means for you:

Are you a shareholder? ONGC’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means ONGC still has room to improve shareholder returns by raising debt to fund new investments. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.