This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about Return on Equity using a real-life example.
Marvel Decor Limited’s (NSE:MDL) most recent return on equity was a substandard 7.8% relative to its industry performance of 12.8% over the past year. MDL’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 MDL’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of MDL’s returns. Let me show you what I mean by this.
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Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 7.8% implies ₹0.078 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
ROE is measured against cost of equity in order to determine the efficiency of Marvel Decor’s equity capital deployed. Its cost of equity is 13.5%. This means Marvel Decor’s returns actually do not cover its own cost of equity, with a discrepancy of -5.7%. 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
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 Marvel Decor can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Marvel Decor currently has. At 5.8%, Marvel Decor’s debt-to-equity ratio appears low and indicates that Marvel Decor still has room to increase leverage and grow its profits.