Linde India Limited (NSEI:LINDEINDIA) delivered a less impressive 1.10% ROE over the past year, compared to the 14.34% return generated by its industry. 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 LINDEINDIA’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of LINDEINDIA’s returns. Let me show you what I mean by this. See our latest analysis for Linde India
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Linde India’s profit against the level of its shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.01 in earnings from this. 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 Linde India, which is 13.40%. Given a discrepancy of -12.30% between return and cost, this indicated that Linde India may be paying more for its capital than what it’s generating in return. ROE can be broken down into three different 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. The other component, asset turnover, illustrates how much revenue Linde India can make from its 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 Linde India’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a balanced 100.33%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? LINDEINDIA exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means LINDEINDIA 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%.