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.
Hikal Limited (NSE:HIKAL) outperformed the Pharmaceuticals industry on the basis of its ROE – producing a higher 11.54% relative to the peer average of 10.89% over the past 12 months. While the impressive ratio tells us that HIKAL has made significant profits from little equity capital, ROE doesn’t tell us if HIKAL has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable HIKAL’s ROE is.
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Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Hikal’s profit against the level of 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
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 Hikal, which is 13.55%. Since Hikal’s return does not cover its cost, with a difference of -2.01%, this means its current use of equity is not efficient and not sustainable. Very simply, Hikal pays more 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Hikal can make from its 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 Hikal currently has. Currently the debt-to-equity ratio stands at a balanced 94.88%, which means its above-average ROE is driven by its ability to grow its profit without a significant 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. Hikal exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of industry-beating returns. Although ROE can be a useful metric, it is only a small part of diligent research.