The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want a simplistic look at the return on Cummins India Limited (BOM:500480) stock.
Cummins India Limited (BOM:500480) delivered an ROE of 17.28% over the past 12 months, which is an impressive feat relative to its industry average of 10.80% during the same period. Though, the impressiveness of 500480’s ROE is contingent on whether this industry-beating level can be sustained. This can be measured by looking at the company’s financial leverage. With more debt, 500480 can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further. See our latest analysis for Cummins India
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. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Construction Machinery and Heavy Trucks industry may want to choose the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
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 Cummins India, which is 13.55%. This means Cummins India returns enough to cover its own cost of equity, with a buffer of 3.74%. This sustainable practice implies that the company pays less 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:
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 Cummins India’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if Cummins India’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Cummins India’s debt-to-equity ratio. The ratio currently stands at a sensible 6.24%, meaning Cummins India has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Cummins India exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.
For Cummins India, there are three relevant aspects you should look at:
- Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Valuation: What is Cummins India worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Cummins India is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Cummins India? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!