This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
With an ROE of 15.5%, Banco Products (India) Limited (NSE:BANCOINDIA) outpaced its own industry which delivered a less exciting 13.9% over the past year. While the impressive ratio tells us that BANCOINDIA has made significant profits from little equity capital, ROE doesn’t tell us if BANCOINDIA has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable BANCOINDIA’s ROE is.
Check out our latest analysis for Banco Products (India)
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Banco Products (India)’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 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 Banco Products (India), which is 13.5%. Since Banco Products (India)’s return covers its cost in excess of 2.0%, its use of equity capital is efficient and likely to be sustainable. Simply put, Banco Products (India) pays less 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Banco Products (India) can generate with its current 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 Banco Products (India) currently has. At 4.2%, Banco Products (India)’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.