The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Alembic Limited (NSE:ALEMBICLTD) outperformed the Pharmaceuticals industry on the basis of its ROE – producing a higher 15.01% relative to the peer average of 11.32% over the past 12 months. Superficially, this looks great since we know that ALEMBICLTD has generated big profits with little equity capital; however, ROE doesn’t tell us how much ALEMBICLTD has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of ALEMBICLTD’s ROE.
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Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Alembic’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. 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 measured against cost of equity in order to determine the efficiency of Alembic’s equity capital deployed. Its cost of equity is 13.55%. Given a positive discrepancy of 1.46% between return and cost, this indicates that Alembic pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Alembic 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 ROE can be artificially increased through excessive borrowing, we should check Alembic’s historic debt-to-equity ratio. Currently Alembic has virtually no debt, which means its returns are predominantly driven by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.