I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
With an ROE of 31.9%, Apollo Sindoori Hotels Limited (NSE:APOLSINHOT) outpaced its own industry which delivered a less exciting 5.9% over the past year. While the impressive ratio tells us that APOLSINHOT has made significant profits from little equity capital, ROE doesn’t tell us if APOLSINHOT has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether APOLSINHOT’s ROE is actually sustainable.
Check out our latest analysis for Apollo Sindoori Hotels
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Apollo Sindoori Hotels’s profit against the level of 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
Returns are usually compared to costs to measure the efficiency of capital. Apollo Sindoori Hotels’s cost of equity is 13.5%. Since Apollo Sindoori Hotels’s return covers its cost in excess of 18.4%, its use of equity capital is efficient and likely to be sustainable. Simply put, Apollo Sindoori Hotels pays less 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. Asset turnover reveals how much revenue can be generated from Apollo Sindoori Hotels’s 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 inflated by excessive debt, we need to examine Apollo Sindoori Hotels’s debt-to-equity level. At 1.2%, Apollo Sindoori Hotels’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Apollo Sindoori Hotels exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.