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With an ROE of 23.12%, Pidilite Industries Limited (NSEI:PIDILITIND) outpaced its own industry which delivered a less exciting 14.74% over the past year. While the impressive ratio tells us that PIDILITIND has made significant profits from little equity capital, ROE doesn’t tell us if PIDILITIND has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether PIDILITIND’s ROE is actually sustainable. View our latest analysis for Pidilite Industries
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Pidilite Industries’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. 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
Returns are usually compared to costs to measure the efficiency of capital. Pidilite Industries’s cost of equity is 13.40%. Given a positive discrepancy of 9.72% between return and cost, this indicates that Pidilite Industries pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be broken down into three different 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 Pidilite Industries can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Pidilite Industries’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 2.43%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Pidilite Industries’s above-industry ROE is encouraging, and is also in excess of 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.