Khaitan (India) Limited (NSEI:KHAITANLTD) delivered an ROE of 13.01% over the past 12 months, which is an impressive feat relative to its industry average of 12.29% during the same period. On the surface, this looks fantastic since we know that KHAITANLTD has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether KHAITANLTD’s ROE is actually sustainable. See our latest analysis for Khaitan (India)
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of 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
Returns are usually compared to costs to measure the efficiency of capital. Khaitan (India)’s cost of equity is 22.74%. Since Khaitan (India)’s return does not cover its cost, with a difference of -9.73%, this means its current use of equity is not efficient and not sustainable. Very simply, Khaitan (India) pays more for its capital than what it generates in return. ROE can be split up into three useful 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 Khaitan (India) can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Khaitan (India)’s historic debt-to-equity ratio. At 102.80%, Khaitan (India)’s debt-to-equity ratio appears balanced and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? KHAITANLTD exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. Since its high ROE is not fuelled by unsustainable debt, investors shouldn’t give up as KHAITANLTD still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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%.