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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 13.3%, Wendt (India) Limited (NSE:WENDT) outpaced its own industry which delivered a less exciting 11.9% over the past year. Superficially, this looks great since we know that WENDT has generated big profits with little equity capital; however, ROE doesn’t tell us how much WENDT has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable WENDT’s ROE is.
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Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Wendt (India)’s profit against the level of its shareholders’ equity. An ROE of 13.3% implies ₹0.13 returned on every ₹1 invested. 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
ROE is measured against cost of equity in order to determine the efficiency of Wendt (India)’s equity capital deployed. Its cost of equity is 13.5%. This means Wendt (India)’s returns actually do not cover its own cost of equity, with a discrepancy of -0.2%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. 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. The other component, asset turnover, illustrates how much revenue Wendt (India) 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 artificially increased through excessive borrowing, we should check Wendt (India)’s historic debt-to-equity ratio. Currently, Wendt (India) has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.