The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Nila Infrastructures Limited (NSE:NILA) delivered an ROE of 19.4% over the past 12 months, which is an impressive feat relative to its industry average of 3.7% during the same period. On the surface, this looks fantastic since we know that NILA has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable NILA’s ROE is.
See our latest analysis for Nila Infrastructures
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Nila Infrastructures’s profit relative to its shareholders’ equity. An ROE of 19.4% implies ₹0.19 returned on every ₹1 invested. 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 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 Nila Infrastructures, which is 14.3%. This means Nila Infrastructures returns enough to cover its own cost of equity, with a buffer of 5.0%. This sustainable practice implies that the company 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Nila Infrastructures 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 artificially increased through excessive borrowing, we should check Nila Infrastructures’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a balanced 99.6%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.