With an ROE of 12.09%, Pulz Electronics Limited (NSEI:PULZ) returned in-line to its own industry which delivered 14.03% over the past year. But what is more interesting is whether PULZ can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of PULZ’s returns. See our latest analysis for Pulz Electronics
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 12.09% implies ₹0.12 returned on every ₹1 invested, so the higher the return, the better. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Consumer Electronics sector by choosing 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 Pulz Electronics 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. Pulz Electronics’s cost of equity is 13.40%. Since Pulz Electronics’s return does not cover its cost, with a difference of -1.31%, this means its current use of equity is not efficient and not sustainable. Very simply, Pulz Electronics 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Pulz Electronics’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Pulz Electronics is fuelling ROE by excessively raising debt. Ideally, Pulz Electronics should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The most recent ratio is 69.87%, which is sensible and indicates Pulz Electronics has not taken on too much leverage. Thus, we can conclude its current ROE is generated from its capacity to increase profit without a large debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Pulz Electronics’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.
For Pulz Electronics, I’ve put together three pertinent aspects you should further examine:
- 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.
- Future Earnings: How does Pulz Electronics’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Pulz Electronics? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!