Godrej Consumer Products Limited (NSEI:GODREJCP) delivered a less impressive 26.79% ROE over the past year, compared to the 29.83% return generated by its industry. GODREJCP’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 GODREJCP’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of GODREJCP’s returns. Check out our latest analysis for Godrej Consumer Products
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Godrej Consumer Products’s profit relative to its shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.27 in earnings from this. 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
ROE is measured against cost of equity in order to determine the efficiency of Godrej Consumer Products’s equity capital deployed. Its cost of equity is 13.40%. Some of Godrej Consumer Products’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 Godrej Consumer Products which is reassuring. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Godrej Consumer Products 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 Godrej Consumer Products currently has. Currently the debt-to-equity ratio stands at a reasonable 55.66%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? While GODREJCP exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity, which means its generating value for shareholders. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. 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%.