In This Article:
I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
Prestige Estates Projects Limited (NSE:PRESTIGE) outperformed the Real Estate Development industry on the basis of its ROE – producing a higher 8.8% relative to the peer average of 3.6% over the past 12 months. While the impressive ratio tells us that PRESTIGE has made significant profits from little equity capital, ROE doesn’t tell us if PRESTIGE has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether PRESTIGE’s ROE is actually sustainable.
View our latest analysis for Prestige Estates Projects
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Prestige Estates Projects’s profit against the level of 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
Returns are usually compared to costs to measure the efficiency of capital. Prestige Estates Projects’s cost of equity is 16.6%. Given a discrepancy of -7.8% between return and cost, this indicated that Prestige Estates Projects may be paying more for its capital than what it’s generating 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
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 Prestige Estates Projects can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Prestige Estates Projects currently has. The debt-to-equity ratio currently stands at a balanced 149%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge 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. Prestige Estates Projects exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. Although ROE can be a useful metric, it is only a small part of diligent research.