This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about Return on Equity using a real-life example.
SJVN Limited (NSE:SJVN) delivered an ROE of 11.45% over the past 12 months, which is relatively in-line with its industry average of 12.59% during the same period. But what is more interesting is whether SJVN can sustain or improve on this level of return. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of SJVN’s returns. Let me show you what I mean by this.
Breaking down Return on Equity
Return on Equity (ROE) is a measure of SJVN’s profit relative to its shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.11 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Electric Utilities sector by investing in the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
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 SJVN, which is 13.55%. Given a discrepancy of -2.10% between return and cost, this indicated that SJVN 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:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue SJVN can generate with its current 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 SJVN is fuelling ROE by excessively raising debt. Ideally, SJVN should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The most recent ratio is 19.02%, which is sensible and indicates SJVN has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and SJVN still has room to increase leverage and grow future returns.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. SJVN’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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For SJVN, there are three essential factors 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 SJVN 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 SJVN is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of SJVN? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.