This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between Sun Pharmaceutical Industries Limited (NSE:SUNPHARMA)’s return fundamentals and stock market performance.
Sun Pharmaceutical Industries Limited (NSE:SUNPHARMA) delivered a less impressive 6.21% ROE over the past year, compared to the 10.69% return generated by its industry. Though SUNPHARMA’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on SUNPHARMA’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of SUNPHARMA’s returns. View out our latest analysis for Sun Pharmaceutical Industries
What you must know about ROE
Return on Equity (ROE) weighs Sun Pharmaceutical Industries’s profit against the level of its shareholders’ equity. An ROE of 6.21% implies ₹0.062 returned on every ₹1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Pharmaceuticals 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.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Sun Pharmaceutical Industries’s cost of equity is 13.55%. Since Sun Pharmaceutical Industries’s return does not cover its cost, with a difference of -7.33%, this means its current use of equity is not efficient and not sustainable. Very simply, Sun Pharmaceutical Industries 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Sun Pharmaceutical Industries’s 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 Sun Pharmaceutical Industries’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 26.41%, which is sensible and indicates Sun Pharmaceutical Industries has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and Sun Pharmaceutical Industries still has room to increase leverage and grow future returns.
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. Sun Pharmaceutical Industries’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Sun Pharmaceutical Industries’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 Sun Pharmaceutical Industries, 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 Sun Pharmaceutical Industries 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 Sun Pharmaceutical Industries is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Sun Pharmaceutical Industries? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!