In This Article:
I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
Mahamaya Steel Industries Limited (NSE:MAHASTEEL) generated a below-average return on equity of 2.6% in the past 12 months, while its industry returned 11.8%. Though MAHASTEEL’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 MAHASTEEL’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of MAHASTEEL’s returns.
View our latest analysis for Mahamaya Steel Industries
What you must know about ROE
Return on Equity (ROE) is a measure of Mahamaya Steel Industries’s profit relative to its shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.026 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Mahamaya Steel Industries’s equity capital deployed. Its cost of equity is 18.2%. Since Mahamaya Steel Industries’s return does not cover its cost, with a difference of -15.7%, this means its current use of equity is not efficient and not sustainable. Very simply, Mahamaya Steel Industries pays more 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Mahamaya Steel Industries can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Mahamaya Steel Industries’s debt-to-equity level. The debt-to-equity ratio currently stands at a balanced 109%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.