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.
With an ROE of 25.2%, Sundram Fasteners Limited (NSE:SUNDRMFAST) outpaced its own industry which delivered a less exciting 13.9% over the past year. Superficially, this looks great since we know that SUNDRMFAST has generated big profits with little equity capital; however, ROE doesn’t tell us how much SUNDRMFAST has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether SUNDRMFAST’s ROE is actually sustainable.
See our latest analysis for Sundram Fasteners
What you must know about ROE
Return on Equity (ROE) weighs Sundram Fasteners’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 Sundram Fasteners’s equity capital deployed. Its cost of equity is 13.5%. This means Sundram Fasteners returns enough to cover its own cost of equity, with a buffer of 11.7%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be split up into three useful 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 Sundram Fasteners 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 Sundram Fasteners’s historic debt-to-equity ratio. At 45.5%, Sundram Fasteners’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.