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 Rupa & Company Limited (NSE:RUPA).
With an ROE of 17.27%, Rupa & Company Limited (NSE:RUPA) outpaced its own industry which delivered a less exciting 7.50% over the past year. While the impressive ratio tells us that RUPA has made significant profits from little equity capital, ROE doesn’t tell us if RUPA has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether RUPA’s ROE is actually sustainable. Check out our latest analysis for Rupa
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Rupa’s profit relative to its shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.17 in earnings from this. 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 Rupa’s equity capital deployed. Its cost of equity is 13.55%. Given a positive discrepancy of 3.73% between return and cost, this indicates that Rupa pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Rupa can generate with its current 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 Rupa currently has. The debt-to-equity ratio currently stands at a low 22.99%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge 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. Rupa exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.