Will Chromatic India Limited (NSE:CHROMATIC) Continue To Underperform Its Industry?

Chromatic India Limited (NSEI:CHROMATIC) generated a below-average return on equity of 0.0003% in the past 12 months, while its industry returned 14.86%. 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. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of CHROMATIC's returns. Let me show you what I mean by this. See our latest analysis for Chromatic India

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) weighs Chromatic India’s profit against the level of its shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Specialty Chemicals sector by investing in 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 measured against cost of equity in order to determine the efficiency of Chromatic India’s equity capital deployed. Its cost of equity is 13.40%. Given a discrepancy of -13.40% between return and cost, this indicated that Chromatic India may be paying more for its capital than what it’s generating 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. The other component, asset turnover, illustrates how much revenue Chromatic India can make from its 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 Chromatic India’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a sensible 1.16%, meaning Chromatic India has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden and still has headroom to grow returns to industry average.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Chromatic India exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For Chromatic India, there are three important factors 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.