Chromatic India Limited (NSE:CHROMATIC): Can It Deliver A Superior ROE To The Industry?

Chromatic India Limited’s (NSEI:CHROMATIC) most recent return on equity was a substandard 0.000003% relative to its industry performance of 14.28% over the past year. CHROMATIC's results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on CHROMATIC’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of CHROMATIC's returns. See our latest analysis for Chromatic 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 in earnings from this. Investors seeking to maximise their return in the Specialty Chemicals 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.

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 Chromatic India, which is 13.40%. Since Chromatic India’s return does not cover its cost, with a difference of -13.40%, this means its current use of equity is not efficient and not sustainable. Very simply, Chromatic India pays more for its capital than what it generates in return. ROE can be dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

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 Chromatic India’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if Chromatic 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 Chromatic India’s debt-to-equity ratio. Currently the ratio stands at 1.16%, which is very low. This means Chromatic India has not taken on leverage, which could explain its below-average ROE. Chromatic India still has headroom to take on more leverage in order to grow its returns.

Next Steps:

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. Chromatic India’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Chromatic India’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.

For Chromatic India, there are three important aspects you should further examine:

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 Chromatic 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 Chromatic India is currently mispriced by the market.

3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Chromatic 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!

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.