Adani Transmissions Limited (NSEI:ADANITRANS) outperformed the Electric Utilities industry on the basis of its ROE – producing a higher 36.32% relative to the peer average of 11.84% over the past 12 months. Superficially, this looks great since we know that ADANITRANS has generated big profits with little equity capital; however, ROE doesn’t tell us how much ADANITRANS has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether ADANITRANS’s ROE is actually sustainable. View our latest analysis for Adani Transmissions
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 36.32% implies ₹0.36 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
Returns are usually compared to costs to measure the efficiency of capital. Adani Transmissions’s cost of equity is 13.40%. Given a positive discrepancy of 22.92% between return and cost, this indicates that Adani Transmissions pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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. Asset turnover shows how much revenue Adani Transmissions can generate with its current 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 financial leverage can artificially inflate ROE, we need to look at how much debt Adani Transmissions currently has. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its above-average ROE is driven by significant debt levels.
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. Adani Transmissions’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Adani Transmissions’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.