With an ROE of 39.74%, Procter & Gamble Hygiene and Health Care Limited (NSEI:PGHH) outpaced its own industry which delivered a less exciting 29.83% over the past year. Superficially, this looks great since we know that PGHH has generated big profits with little equity capital; however, ROE doesn’t tell us how much PGHH has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether PGHH’s ROE is actually sustainable. View our latest analysis for Procter & Gamble Hygiene and Health Care
What you must know about ROE
Return on Equity (ROE) weighs Procter & Gamble Hygiene and Health Care’s profit against the level of its shareholders’ equity. An ROE of 39.74% implies ₹0.4 returned on every ₹1 invested. 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 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 Procter & Gamble Hygiene and Health Care, which is 13.40%. Given a positive discrepancy of 26.34% between return and cost, this indicates that Procter & Gamble Hygiene and Health Care pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Procter & Gamble Hygiene and Health Care 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 ROE can be inflated by excessive debt, we need to examine Procter & Gamble Hygiene and Health Care’s debt-to-equity level. Currently Procter & Gamble Hygiene and Health Care has virtually no debt, which means its returns are predominantly driven by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.