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 begin learning the link between company’s fundamentals and stock market performance.
JK Lakshmi Cement Limited (NSE:JKLAKSHMI) delivered a less impressive 3.0% ROE over the past year, compared to the 8.0% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into JKLAKSHMI’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of JKLAKSHMI’s returns. Let me show you what I mean by this.
View our latest analysis for JK Lakshmi Cement
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of JK Lakshmi Cement’s profit relative to its shareholders’ equity. An ROE of 3.0% implies ₹0.030 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 JK Lakshmi Cement, which is 15.2%. Given a discrepancy of -12.2% between return and cost, this indicated that JK Lakshmi Cement may be paying more for its capital than what it’s generating in return. ROE can be broken down into three different 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 JK Lakshmi Cement can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt JK Lakshmi Cement currently has. Currently the debt-to-equity ratio stands at a high 176%, which means its below-average ROE is already being driven by significant debt levels.