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This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Surana Solar Limited (NSE:SURANASOL) delivered a less impressive 1.7% ROE over the past year, compared to the 11.4% return generated by its industry. SURANASOL’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on SURANASOL’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of SURANASOL’s returns. Let me show you what I mean by this.
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Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Surana Solar’s profit relative to its shareholders’ equity. An ROE of 1.7% implies ₹0.017 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. Surana Solar’s cost of equity is 16.2%. This means Surana Solar’s returns actually do not cover its own cost of equity, with a discrepancy of -14.5%. 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 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 reveals how much revenue can be generated from Surana Solar’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 Surana Solar currently has. Currently the debt-to-equity ratio stands at a reasonable 47.3%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.