In This Article:
This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about Return on Equity using a real-life example.
Gujarat State Petronet Limited (NSE:GSPL) delivered an ROE of 29.19% over the past 12 months, which is an impressive feat relative to its industry average of 19.79% during the same period. While the impressive ratio tells us that GSPL has made significant profits from little equity capital, ROE doesn’t tell us if GSPL has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of GSPL’s ROE.
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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. An ROE of 29.19% implies ₹0.29 returned on every ₹1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
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 Gujarat State Petronet, which is 13.55%. Since Gujarat State Petronet’s return covers its cost in excess of 15.64%, its use of equity capital is efficient and likely to be sustainable. Simply put, Gujarat State Petronet pays less 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
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 Gujarat State Petronet 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 Gujarat State Petronet’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a balanced 121.01%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.