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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.
ABB India Limited (NSE:ABB) outperformed the Heavy Electrical Equipment industry on the basis of its ROE – producing a higher 12.4% relative to the peer average of 10.6% over the past 12 months. While the impressive ratio tells us that ABB has made significant profits from little equity capital, ROE doesn’t tell us if ABB has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of ABB’s ROE.
View our latest analysis for ABB India
What you must know about ROE
Return on Equity (ROE) weighs ABB India’s profit against the level of its shareholders’ equity. An ROE of 12.4% implies ₹0.12 returned on every ₹1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing 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 ABB India, which is 15.2%. Given a discrepancy of -2.8% between return and cost, this indicated that ABB India may be paying more for its capital than what it’s generating 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 ABB India can generate with its current 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 financial leverage can artificially inflate ROE, we need to look at how much debt ABB India currently has. Currently ABB India 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.