This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
GKW Limited (NSE:GKWLIMITED) generated a below-average return on equity of 1.9% in the past 12 months, while its industry returned 8.8%. GKWLIMITED’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on GKWLIMITED’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of GKWLIMITED’s returns.
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Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs GKW’s profit against the level of its shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.019 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
Returns are usually compared to costs to measure the efficiency of capital. GKW’s cost of equity is 13.5%. Given a discrepancy of -11.7% between return and cost, this indicated that GKW 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
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 GKW can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check GKW’s historic debt-to-equity ratio. Currently, GKW has no debt which means its returns are driven purely by equity capital. This could explain why GKW’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. GKW’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.