This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.
Huhtamaki PPL Limited (NSE:PAPERPROD) outperformed the Paper Packaging industry on the basis of its ROE – producing a higher 13.0% relative to the peer average of 9.8% over the past 12 months. While the impressive ratio tells us that PAPERPROD has made significant profits from little equity capital, ROE doesn’t tell us if PAPERPROD has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of PAPERPROD’s ROE.
See our latest analysis for Huhtamaki PPL
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Huhtamaki PPL’s profit against the level of its shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.13 in earnings from this. 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 Huhtamaki PPL, which is 13.5%. Given a discrepancy of -0.6% between return and cost, this indicated that Huhtamaki PPL 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Huhtamaki PPL can generate with its current 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 artificially increased through excessive borrowing, we should check Huhtamaki PPL’s historic debt-to-equity ratio. At 70.9%, Huhtamaki PPL’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.