Eimco Elecon (India) Limited (NSEI:EIMCOELECO) performed in line with its construction machinery and heavy trucks industry on the basis of its ROE – producing a return of8.17% relative to the peer average of 10.26% over the past 12 months. But what is more interesting is whether EIMCOELECO can sustain or improve on this level of return. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of EIMCOELECO’s returns. Let me show you what I mean by this. See our latest analysis for Eimco Elecon (India)
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.08 in earnings from this. 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 misleading as each firm has different costs of equity and debt levels i.e. the more debt Eimco Elecon (India) has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Eimco Elecon (India)’s cost of equity is 13.40%. Since Eimco Elecon (India)’s return does not cover its cost, with a difference of -5.24%, this means its current use of equity is not efficient and not sustainable. Very simply, Eimco Elecon (India) 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:
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. The other component, asset turnover, illustrates how much revenue Eimco Elecon (India) can make from its 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. We can assess whether Eimco Elecon (India) is fuelling ROE by excessively raising debt. Ideally, Eimco Elecon (India) should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently Eimco Elecon (India) has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why Eimco Elecon (India)’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Eimco Elecon (India)’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Eimco Elecon (India)’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Eimco Elecon (India), I’ve put together three fundamental aspects you should further research:
- 1. 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.
- 2. Valuation: What is Eimco Elecon (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 Eimco Elecon (India) is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Eimco Elecon (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!