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.
With an ROE of 12.2%, PVR Limited (NSE:PVR) outpaced its own industry which delivered a less exciting 8.2% over the past year. On the surface, this looks fantastic since we know that PVR has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether PVR’s ROE is actually sustainable.
View our latest analysis for PVR
Breaking down Return on Equity
Return on Equity (ROE) is a measure of PVR’s profit relative to its shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.12 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for PVR, which is 13.5%. Since PVR’s return does not cover its cost, with a difference of -1.3%, this means its current use of equity is not efficient and not sustainable. Very simply, PVR 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue PVR 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 inflated by excessive debt, we need to examine PVR’s debt-to-equity level. Currently the debt-to-equity ratio stands at a reasonable 61.5%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. PVR’s above-industry ROE is noteworthy, but it was not high enough to cover its own 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.