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.

Piramal Enterprises Limited (NSE:PEL) outperformed the Pharmaceuticals industry on the basis of its ROE – producing a higher 17.9% relative to the peer average of 11.3% over the past 12 months. While the impressive ratio tells us that PEL has made significant profits from little equity capital, ROE doesn’t tell us if PEL has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable PEL’s ROE is.

View our latest analysis for Piramal Enterprises

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 ₹0.18 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is measured against cost of equity in order to determine the efficiency of Piramal Enterprises’s equity capital deployed. Its cost of equity is 13.5%. Given a positive discrepancy of 4.4% between return and cost, this indicates that Piramal Enterprises pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be broken down into three different 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 Piramal Enterprises 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 Piramal Enterprises’s historic debt-to-equity ratio. At 167%, Piramal Enterprises’s debt-to-equity ratio appears relatively high and indicates the above-average ROE is generated by significant leverage levels.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Piramal Enterprises exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Piramal Enterprises’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.