Why Tanla Solutions Limited’s (NSE:TANLA) ROE Of 2.78% Does Not Tell The Whole Story

I am writing today to help inform people who are new to the stock market and want a simplistic look at the return on Tanla Solutions Limited (NSE:TANLA) stock.

Tanla Solutions Limited (NSE:TANLA) generated a below-average return on equity of 2.78% in the past 12 months, while its industry returned 11.52%. Though TANLA’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 TANLA’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of TANLA’s returns. Let me show you what I mean by this. Check out our latest analysis for Tanla Solutions

Breaking down Return on Equity

Return on Equity (ROE) is a measure of Tanla Solutions’s profit relative to its shareholders’ equity. An ROE of 2.78% implies ₹0.028 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 Application Software 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 Tanla Solutions 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 Tanla Solutions, which is 13.55%. Given a discrepancy of -10.77% between return and cost, this indicated that Tanla Solutions may be paying more for its capital than what it’s generating in return. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

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

NSEI:TANLA Last Perf July 9th 18
NSEI:TANLA Last Perf July 9th 18

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 Tanla Solutions’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. We can assess whether Tanla Solutions is fuelling ROE by excessively raising debt. Ideally, Tanla Solutions should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently, Tanla Solutions has no debt which means its returns are driven purely by equity capital. This could explain why Tanla Solutions’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.

NSEI:TANLA Historical Debt July 9th 18
NSEI:TANLA Historical Debt July 9th 18

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Tanla Solutions’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.

For Tanla Solutions, I’ve compiled three pertinent factors 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 Tanla Solutions 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 Tanla Solutions is currently mispriced by the market.
  3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Tanla Solutions? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!