The United Nilgiri Tea Estates Company Limited (NSEI:UNITEDTEA) generated a below-average return on equity of 12.09% in the past 12 months, while its industry returned 12.29%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into UNITEDTEA’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of UNITEDTEA’s returns. Let me show you what I mean by this. See our latest analysis for United Nilgiri Tea Estates

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. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.12 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. United Nilgiri Tea Estates’s cost of equity is 13.40%. Given a discrepancy of -1.31% between return and cost, this indicated that United Nilgiri Tea Estates 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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue United Nilgiri Tea Estates can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check United Nilgiri Tea Estates’s historic debt-to-equity ratio. Currently, United Nilgiri Tea Estates has no debt which means its returns are driven purely by equity capital. This could explain why United Nilgiri Tea Estates’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.