Edelweiss Financial Services Limited (NSEI:EDELWEISS) outperformed the asset management and custody banks industry on the basis of its ROE – producing a higher 14.44% relative to the peer average of 6.32% over the past 12 months. However, whether this above-industry ROE is actually impressive depends on if it can be maintained. This can be measured by looking at the company’s financial leverage. With more debt, EDELWEISS 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. Check out our latest analysis for Edelweiss Financial Services
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 ₹0.14 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Asset Management and Custody Banks sector by investing in 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 Edelweiss Financial Services 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 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 Edelweiss Financial Services, which is 13.93%. Since Edelweiss Financial Services’s return covers its cost in excess of 0.51%, its use of equity capital is efficient and likely to be sustainable. Simply put, Edelweiss Financial Services 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
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 Edelweiss Financial Services’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. 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 Edelweiss Financial Services’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 Edelweiss Financial Services’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. Edelweiss Financial Services’s ROE is impressive relative to the industry average and also covers 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 Edelweiss Financial Services’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Edelweiss Financial Services, there are three key aspects you should look at:
- 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 Edelweiss Financial Services 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 Edelweiss Financial Services is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Edelweiss Financial Services? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!