This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between company’s fundamentals and stock market performance.
Asahi India Glass Limited (NSE:ASAHIINDIA) outperformed the Auto Parts and Equipment industry on the basis of its ROE – producing a higher 17.1% relative to the peer average of 13.9% over the past 12 months. While the impressive ratio tells us that ASAHIINDIA has made significant profits from little equity capital, ROE doesn’t tell us if ASAHIINDIA has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable ASAHIINDIA’s ROE is.
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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. 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. Asahi India Glass’s cost of equity is 13.5%. Given a positive discrepancy of 3.5% between return and cost, this indicates that Asahi India Glass pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be dissected into three distinct 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 reveals how much revenue can be generated from Asahi India Glass’s 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 inflated by excessive debt, we need to examine Asahi India Glass’s debt-to-equity level. Currently the debt-to-equity ratio stands at a balanced 129%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Asahi India Glass’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.