Cholamandalam Investment and Finance Company Limited (NSEI:CHOLAFIN) delivered an ROE of 18.84% over the past 12 months, which is an impressive feat relative to its industry average of 6.62% during the same period. But what is more interesting is whether CHOLAFIN can sustain this above-average ratio. This can be measured by looking at the company’s financial leverage. With more debt, CHOLAFIN 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 Cholamandalam Investment and Finance
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Cholamandalam Investment and Finance’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Consumer Finance 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 Cholamandalam Investment and Finance 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
ROE is measured against cost of equity in order to determine the efficiency of Cholamandalam Investment and Finance’s equity capital deployed. Its cost of equity is 13.40%. Given a positive discrepancy of 5.44% between return and cost, this indicates that Cholamandalam Investment and Finance pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 shows how much revenue Cholamandalam Investment and Finance can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at Cholamandalam Investment and Finance’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is greater than 2.5 times which is very high, indicating Cholamandalam Investment and Finance’s above-average ROE is generated by its significant leverage levels and its ability to grow profit hinges on a substantial debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Cholamandalam Investment and Finance’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Cholamandalam Investment and Finance’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Cholamandalam Investment and Finance, I’ve compiled three pertinent factors 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 Cholamandalam Investment and Finance 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 Cholamandalam Investment and Finance is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Cholamandalam Investment and Finance? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!