This article is intended for those of you who are at the beginning of your investing journey and want a simplistic look at the return on Granules India Limited (BOM:532482) stock.
Granules India Limited (BOM:532482) delivered an ROE of 10.17% over the past 12 months, which is relatively in-line with its industry average of 10.68% during the same period. But what is more interesting is whether 532482 can sustain or improve on this level of return. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 532482's returns. See our latest analysis for Granules India
What you must know about ROE
Return on Equity (ROE) is a measure of Granules India’s profit relative to its shareholders’ equity. An ROE of 10.17% implies ₹0.10 returned on every ₹1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Pharmaceuticals 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 Granules India 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 Granules India, which is 13.55%. Since Granules India’s return does not cover its cost, with a difference of -3.38%, this means its current use of equity is not efficient and not sustainable. Very simply, Granules India 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 shows how much revenue Granules India can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Granules India is fuelling ROE by excessively raising debt. Ideally, Granules India should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands at a sensible 73.47%, meaning Granules India has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.
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. Granules 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 Granules 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 Granules India, I've put together three important aspects you should further research:
- 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.
- Valuation: What is Granules 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 Granules India is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Granules 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!