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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 begin learning the link between company’s fundamentals and stock market performance.
With an ROE of 20.3%, Chambal Fertilisers and Chemicals Limited (NSE:CHAMBLFERT) outpaced its own industry which delivered a less exciting 13.1% over the past year. Superficially, this looks great since we know that CHAMBLFERT has generated big profits with little equity capital; however, ROE doesn’t tell us how much CHAMBLFERT has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable CHAMBLFERT’s ROE is.
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What you must know about ROE
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 ₹0.20 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
Returns are usually compared to costs to measure the efficiency of capital. Chambal Fertilisers and Chemicals’s cost of equity is 13.5%. Given a positive discrepancy of 6.8% between return and cost, this indicates that Chambal Fertilisers and Chemicals 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Chambal Fertilisers and Chemicals 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 financial leverage can artificially inflate ROE, we need to look at how much debt Chambal Fertilisers and Chemicals currently has. At over 2.5 times, Chambal Fertilisers and Chemicals’s debt-to-equity ratio is very high and indicates the above-average ROE is generated by significant leverage levels.