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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 learn about Return on Equity using a real-life example.
With an ROE of 24.20%, Sun TV Network Limited (NSE:SUNTV) outpaced its own industry which delivered a less exciting 10.00% over the past year. Superficially, this looks great since we know that SUNTV has generated big profits with little equity capital; however, ROE doesn’t tell us how much SUNTV has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether SUNTV’s ROE is actually sustainable.
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What you must know about ROE
Return on Equity (ROE) weighs Sun TV Network’s profit against the level of its shareholders’ equity. An ROE of 24.20% implies ₹0.24 returned on every ₹1 invested. 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
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 Sun TV Network, which is 13.55%. This means Sun TV Network returns enough to cover its own cost of equity, with a buffer of 10.65%. This sustainable practice implies that the company pays less for its capital than what it generates 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
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 Sun TV Network 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 ROE can be inflated by excessive debt, we need to examine Sun TV Network’s debt-to-equity level. Currently, Sun TV Network has no debt which means its returns are driven purely 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.