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Reliance Industries Limited (NSEI:RELIANCE) delivered a less impressive 12.43% ROE over the past year, compared to the 12.43% return generated by its industry. Though RELIANCE’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 RELIANCE’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of RELIANCE’s returns. See our latest analysis for Reliance Industries
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. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.12 in earnings from this. 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 Reliance Industries’s equity capital deployed. Its cost of equity is 13.40%. Given a discrepancy of -0.97% between return and cost, this indicated that Reliance Industries may be paying more for its capital than what it’s generating 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Reliance Industries’s 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 Reliance Industries’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 64.96%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Reliance Industries’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Reliance Industries’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.