I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
Divi’s Laboratories Limited (NSE:DIVISLAB) outperformed the Life Sciences Tools and Services industry on the basis of its ROE – producing a higher 14.8% relative to the peer average of 9.0% over the past 12 months. On the surface, this looks fantastic since we know that DIVISLAB has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether DIVISLAB’s ROE is actually sustainable.
View our latest analysis for Divi’s Laboratories
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 ₹0.15 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 Divi’s Laboratories, which is 13.5%. Since Divi’s Laboratories’s return covers its cost in excess of 1.3%, its use of equity capital is efficient and likely to be sustainable. Simply put, Divi’s Laboratories pays less for its capital than what it generates 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. The other component, asset turnover, illustrates how much revenue Divi’s Laboratories can make from its 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 financial leverage can artificially inflate ROE, we need to look at how much debt Divi’s Laboratories currently has. The debt-to-equity ratio currently stands at a low 1.1%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.