This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Oil and Natural Gas Corporation Limited (NSE:ONGC) generated a below-average return on equity of 11.9% in the past 12 months, while its industry returned 12.3%. 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. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of ONGC’s returns. Let me show you what I mean by this.
Check out our latest analysis for Oil and Natural Gas
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 11.9% implies ₹0.12 returned on every ₹1 invested. 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
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Oil and Natural Gas, which is 13.5%. This means Oil and Natural Gas’s returns actually do not cover its own cost of equity, with a discrepancy of -1.7%. 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
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 Oil and Natural Gas’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Oil and Natural Gas’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 46.1%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.