AGC Networks Limited’s (NSEI:AGCNET) most recent return on equity was a substandard 14.52% relative to its industry performance of 14.92% over the past year. AGCNET’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on AGCNET’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of AGCNET’s returns. Let me show you what I mean by this. View our latest analysis for AGC Networks
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 14.52% implies ₹0.15 returned on every ₹1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. AGC Networks’s cost of equity is 13.40%. Some of AGC Networks’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for AGC Networks which is reassuring. 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 shows how much revenue AGC Networks 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 financial leverage can artificially inflate ROE, we need to look at how much debt AGC Networks currently has. At 232.88%, AGC Networks’s debt-to-equity ratio appears relatively high and indicates the below-average ROE is already being generated by significant leverage levels.
What this means for you:
Are you a shareholder? Even though AGCNET returned below the industry average, its ROE comes in excess of its cost of equity. However, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more AGCNET shares. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.