I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
Future Retail Limited’s (NSE:FRETAIL) most recent return on equity was a substandard 0.5% relative to its industry performance of 12.3% over the past year. FRETAIL’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on FRETAIL’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of FRETAIL’s returns.
Check out our latest analysis for Future Retail
What you must know about ROE
Return on Equity (ROE) weighs Future Retail’s profit against the level of its shareholders’ equity. An ROE of 0.5% implies ₹0.0053 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. Future Retail’s cost of equity is 15.8%. Given a discrepancy of -15.3% between return and cost, this indicated that Future Retail may be paying more for its capital than what it’s generating in return. 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
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 Future Retail 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 Future Retail currently has. Currently the debt-to-equity ratio stands at a reasonable 41.5%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Future Retail’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.