Dr Reddy’s Laboratories Limited (NSEI:DRREDDY) delivered a less impressive 9.50% ROE over the past year, compared to the 13.67% return generated by its industry. Though DRREDDY’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 DRREDDY’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of DRREDDY’s returns. Check out our latest analysis for Dr. Reddy’s Laboratories
Breaking down Return on Equity
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 ₹0.1 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 Dr. Reddy’s Laboratories, which is 13.40%. Given a discrepancy of -3.90% between return and cost, this indicated that Dr. Reddy’s Laboratories may be paying more for its capital than what it’s generating 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 shows how much revenue Dr. Reddy’s Laboratories can generate with its current 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 ROE can be artificially increased through excessive borrowing, we should check Dr. Reddy’s Laboratories’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 44.05%, meaning Dr. Reddy’s Laboratories still has headroom to borrow debt to increase profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Dr. Reddy’s Laboratories’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Dr. Reddy’s Laboratories’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.