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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 start learning about core concepts of fundamental analysis on practical examples from today’s market.
Ingersoll-Rand (India) Limited’s (NSE:INGERRAND) most recent return on equity was a substandard 8.5% relative to its industry performance of 11.9% over the past year. INGERRAND’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 INGERRAND’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of INGERRAND’s returns.
Check out our latest analysis for Ingersoll-Rand (India)
What you must know about ROE
Return on Equity (ROE) is a measure of Ingersoll-Rand (India)’s profit relative to its shareholders’ equity. An ROE of 8.5% implies ₹0.085 returned on every ₹1 invested. 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
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 Ingersoll-Rand (India), which is 13.5%. Since Ingersoll-Rand (India)’s return does not cover its cost, with a difference of -5.0%, this means its current use of equity is not efficient and not sustainable. Very simply, Ingersoll-Rand (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 Ingersoll-Rand (India) 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 Ingersoll-Rand (India) currently has. Currently, Ingersoll-Rand (India) has no debt which means its returns are driven purely by equity capital. This could explain why Ingersoll-Rand (India)’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.