Biocon Limited’s (NSEI:BIOCON) most recent return on equity was a substandard 10.42% relative to its industry performance of 16.12% over the past year. Though BIOCON’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 BIOCON’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of BIOCON’s returns. See our latest analysis for Biocon
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Biocon’s profit relative to its shareholders’ equity. An ROE of 10.42% implies ₹0.1 returned on every ₹1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. Biocon’s cost of equity is 16.65%. Given a discrepancy of -6.24% between return and cost, this indicated that Biocon 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
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 Biocon can generate with its current 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 Biocon currently has. At 42.36%, Biocon’s debt-to-equity ratio appears low and indicates that Biocon still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? BIOCON’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means BIOCON 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%.