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Mahanagar Gas Limited (NSEI:MGL) delivered an ROE of 24.11% over the past 12 months, which is an impressive feat relative to its industry average of 13.26% during the same period. Superficially, this looks great since we know that MGL has generated big profits with little equity capital; however, ROE doesn’t tell us how much MGL has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable MGL’s ROE is. View our latest analysis for Mahanagar Gas
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Mahanagar Gas’s profit against the level of its shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.24 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Mahanagar Gas’s equity capital deployed. Its cost of equity is 13.40%. Since Mahanagar Gas’s return covers its cost in excess of 10.71%, its use of equity capital is efficient and likely to be sustainable. Simply put, Mahanagar Gas pays less 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Mahanagar Gas can make from its 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 ROE can be inflated by excessive debt, we need to examine Mahanagar Gas’s debt-to-equity level. Currently Mahanagar Gas 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.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Mahanagar Gas’s above-industry ROE is encouraging, and is also in excess of its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.