Oil and Natural Gas Corporation Limited (NSEI:ONGC) delivered a less impressive 9.53% ROE over the past year, compared to the 12.15% return generated by its industry. ONGC’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 ONGC’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of ONGC’s returns. Check out our latest analysis for Oil and Natural Gas
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Oil and Natural Gas’s profit against the level of its shareholders’ equity. An ROE of 9.53% implies ₹0.1 returned on every ₹1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. Oil and Natural Gas’s cost of equity is 13.55%. This means Oil and Natural Gas’s returns actually do not cover its own cost of equity, with a discrepancy of -4.01%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Oil and Natural Gas’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 Oil and Natural Gas’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 25.93%, which means Oil and Natural Gas still has headroom to take on more leverage in order to increase profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Oil and Natural Gas exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.