Precision Camshafts Limited (NSEI:PRECAM) delivered a less impressive 12.65% ROE over the past year, compared to the 13.35% return generated by its industry. PRECAM’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 PRECAM’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of PRECAM’s returns. Let me show you what I mean by this. See our latest analysis for Precision Camshafts
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Precision Camshafts’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 Precision Camshafts’s equity capital deployed. Its cost of equity is 13.40%. This means Precision Camshafts’s returns actually do not cover its own cost of equity, with a discrepancy of -0.75%. 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 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
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 Precision Camshafts’s 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 Precision Camshafts currently has. At 21.86%, Precision Camshafts’s debt-to-equity ratio appears low and indicates that Precision Camshafts still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? PRECAM exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means PRECAM still has room to improve shareholder returns by raising debt to fund new investments. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.