This analysis is intended to introduce important early concepts to people who are starting to invest and looking to gauge the potential return on investment in Vijaya Bank (NSE:VIJAYABANK).
Vijaya Bank (NSE:VIJAYABANK) generated a below-average return on equity of 6.84% in the past 12 months, while its industry returned 7.80%. VIJAYABANK’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on VIJAYABANK’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of VIJAYABANK’s returns. Check out our latest analysis for Vijaya Bank
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. An ROE of 6.84% implies ₹0.068 returned on every ₹1 invested. 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 Vijaya Bank’s equity capital deployed. Its cost of equity is 13.81%. Given a discrepancy of -6.97% between return and cost, this indicated that Vijaya Bank may be paying more for its capital than what it’s generating in return. ROE can be split up into three useful 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 reveals how much revenue can be generated from Vijaya Bank’s 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 Vijaya Bank’s historic debt-to-equity ratio. At 68.69%, Vijaya Bank’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. Vijaya Bank exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Vijaya Bank’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.