The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about Return on Equity using a real-life example.
Coal India Limited (NSE:COALINDIA) outperformed the Coal and Consumable Fuels industry on the basis of its ROE – producing a higher 41.8% relative to the peer average of 12.3% over the past 12 months. While the impressive ratio tells us that COALINDIA has made significant profits from little equity capital, ROE doesn’t tell us if COALINDIA has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable COALINDIA’s ROE is.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Coal India’s profit against the level of its shareholders’ equity. An ROE of 41.8% implies ₹0.42 returned on every ₹1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Coal India’s cost of equity is 13.5%. Given a positive discrepancy of 28.3% between return and cost, this indicates that Coal India pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
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 Coal India can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Coal India’s debt-to-equity level. At 7.6%, Coal India’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Coal India exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Coal India, I’ve put together three pertinent factors you should look at:
- 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 Coal 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 Coal India is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Coal 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!
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.