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.
NATCO Pharma Limited (NSE:NATCOPHARM) outperformed the Pharmaceuticals industry on the basis of its ROE – producing a higher 25.4% relative to the peer average of 11.3% over the past 12 months. While the impressive ratio tells us that NATCOPHARM has made significant profits from little equity capital, ROE doesn’t tell us if NATCOPHARM has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of NATCOPHARM’s ROE.
Check out our latest analysis for NATCO Pharma
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 25.4% implies ₹0.25 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
Returns are usually compared to costs to measure the efficiency of capital. NATCO Pharma’s cost of equity is 13.5%. This means NATCO Pharma returns enough to cover its own cost of equity, with a buffer of 11.9%. This sustainable practice implies that the company 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue NATCO Pharma can generate with its current 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 NATCO Pharma’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 5.6%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. NATCO Pharma’s above-industry ROE is encouraging, and is also in excess of 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.