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This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
With an ROE of 19.9%, Dixon Technologies (India) Limited (NSE:DIXON) outpaced its own industry which delivered a less exciting 12.8% over the past year. Superficially, this looks great since we know that DIXON has generated big profits with little equity capital; however, ROE doesn’t tell us how much DIXON has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether DIXON’s ROE is actually sustainable.
Check out our latest analysis for Dixon Technologies (India)
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Dixon Technologies (India)’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 measured against cost of equity in order to determine the efficiency of Dixon Technologies (India)’s equity capital deployed. Its cost of equity is 13.5%. Given a positive discrepancy of 6.4% between return and cost, this indicates that Dixon Technologies (India) 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Dixon Technologies (India)’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Dixon Technologies (India)’s debt-to-equity level. At 14.2%, Dixon Technologies (India)’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
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. Dixon Technologies (India) exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.