In This Article:
This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between company’s fundamentals and stock market performance.
Bharat Road Network Limited (NSE:BRNL) delivered a less impressive 2.0% ROE over the past year, compared to the 3.6% return generated by its industry. Though BRNL’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on BRNL’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of BRNL’s returns.
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Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.020 in earnings from this. 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 Bharat Road Network, which is 18.4%. Since Bharat Road Network’s return does not cover its cost, with a difference of -16.5%, this means its current use of equity is not efficient and not sustainable. Very simply, Bharat Road Network 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
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 reveals how much revenue can be generated from Bharat Road Network’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Bharat Road Network currently has. The debt-to-equity ratio currently stands at a balanced 92.3%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.