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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 learn about Return on Equity using a real-life example.
Texmo Pipes and Products Limited’s (NSE:TEXMOPIPES) most recent return on equity was a substandard 0.08% relative to its industry performance of 13.1% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into TEXMOPIPES’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of TEXMOPIPES’s returns. Let me show you what I mean by this.
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Breaking down Return on Equity
Return on Equity (ROE) weighs Texmo Pipes and Products’s profit against the level of its 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
ROE is measured against cost of equity in order to determine the efficiency of Texmo Pipes and Products’s equity capital deployed. Its cost of equity is 13.8%. Since Texmo Pipes and Products’s return does not cover its cost, with a difference of -13.8%, this means its current use of equity is not efficient and not sustainable. Very simply, Texmo Pipes and Products 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 Texmo Pipes and Products 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 Texmo Pipes and Products’s debt-to-equity level. At 31.2%, Texmo Pipes and Products’s debt-to-equity ratio appears low and indicates that Texmo Pipes and Products still has room to increase leverage and grow its profits.