Piramal Enterprises Limited (NSEI:PEL) delivered a less impressive 9.55% ROE over the past year, compared to the 13.83% 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 PEL’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of PEL’s returns. See our latest analysis for Piramal Enterprises
Breaking down Return on Equity
Return on Equity (ROE) weighs Piramal Enterprises’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 measured against cost of equity in order to determine the efficiency of Piramal Enterprises’s equity capital deployed. Its cost of equity is 13.40%. This means Piramal Enterprises’s returns actually do not cover its own cost of equity, with a discrepancy of -3.85%. 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 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. Asset turnover shows how much revenue Piramal Enterprises can generate with its current 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 financial leverage can artificially inflate ROE, we need to look at how much debt Piramal Enterprises currently has. The debt-to-equity ratio currently stands at a high 224.64%, meaning the below-average ratio is already being driven by a large amount of debt.
What this means for you:
Are you a shareholder? PEL exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Additionally, with debt capital in excess of equity, the existing ROE is being generated by debt funding, which is something you should be aware of before buying more PEL shares. 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%.