Pilani Investment and Industries Corporation Limited (NSEI:PILANIINVS) delivered a less impressive 3.56% ROE over the past year, compared to the 6.27% return generated by its industry. Though PILANIINVS’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on PILANIINVS’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of PILANIINVS’s returns. View our latest analysis for Pilani Investment and Industries
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if PILANIINVS invests ₹1 in the form of equity, it will generate ₹0.04 in earnings from this. 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 measured against cost of equity in order to determine the efficiency of PILANIINVS’s equity capital deployed. Its cost of equity is 13.40%. This means PILANIINVS’s returns actually do not cover its own cost of equity, with a discrepancy of -9.84%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates 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. Asset turnover reveals how much revenue can be generated from PILANIINVS’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable PILANIINVS’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt PILANIINVS currently has. Currently PILANIINVS has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why PILANIINVS’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
What this means for you:
Are you a shareholder? PILANIINVS’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as PILANIINVS still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.