Agro Phos (India) Limited (NSEI:AGROPHOS) generated a below-average return on equity of 3.97% in the past 12 months, while its industry returned 14.34%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into AGROPHOS’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of AGROPHOS’s returns. See our latest analysis for AGROPHOS
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of AGROPHOS’s profit relative to its shareholders’ equity. An ROE of 3.97% implies ₹0.04 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 AGROPHOS, which is 13.40%. This means AGROPHOS’s returns actually do not cover its own cost of equity, with a discrepancy of -9.43%. 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 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue AGROPHOS 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 AGROPHOS’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt AGROPHOS currently has. Currently the debt-to-equity ratio stands at a reasonable 60.57%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? AGROPHOS’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means AGROPHOS still has room to improve shareholder returns by raising debt to fund new investments. 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%.