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.
Manaksia Coated Metals and Industries Limited (NSE:MNKCMILTD) generated a below-average return on equity of 2.3% in the past 12 months, while its industry returned 11.8%. 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 MNKCMILTD’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of MNKCMILTD’s returns.
Check out our latest analysis for Manaksia Coated Metals and Industries
What you must know about ROE
Return on Equity (ROE) is a measure of Manaksia Coated Metals and Industries’s profit relative to 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 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 Manaksia Coated Metals and Industries, which is 22.2%. Given a discrepancy of -19.9% between return and cost, this indicated that Manaksia Coated Metals and Industries may be paying more for its capital than what it’s generating in return. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Manaksia Coated Metals and Industries can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Manaksia Coated Metals and Industries’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a balanced 139%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.