This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Focus Lighting and Fixtures Limited (NSE:FOCUS) outperformed the Electrical Components and Equipment industry on the basis of its ROE – producing a higher 27.4% relative to the peer average of 10.8% over the past 12 months. Superficially, this looks great since we know that FOCUS has generated big profits with little equity capital; however, ROE doesn’t tell us how much FOCUS has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of FOCUS’s ROE.
See our latest analysis for Focus Lighting and Fixtures
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. 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 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 Focus Lighting and Fixtures, which is 15.2%. Since Focus Lighting and Fixtures’s return covers its cost in excess of 12.2%, its use of equity capital is efficient and likely to be sustainable. Simply put, Focus Lighting and Fixtures 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Focus Lighting and Fixtures can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Focus Lighting and Fixtures currently has. At 10.2%, Focus Lighting and Fixtures’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.