This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Tips Industries Limited (NSE:TIPSINDLTD) generated a below-average return on equity of 5.0% in the past 12 months, while its industry returned 8.2%. Though TIPSINDLTD’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 TIPSINDLTD’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of TIPSINDLTD’s returns.
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What you must know about ROE
Return on Equity (ROE) is a measure of Tips 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. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Tips Industries’s equity capital deployed. Its cost of equity is 13.5%. Given a discrepancy of -8.6% between return and cost, this indicated that Tips 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
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 Tips Industries can generate with its current 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 Tips Industries’s debt-to-equity level. At 51.3%, Tips Industries’s debt-to-equity ratio appears sensible and indicates its ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Tips 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 Tips Industries’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.