Bharat Heavy Electricals Limited (NSEI:BHEL) delivered a less impressive 1.36% ROE over the past year, compared to the 10.79% return generated by its industry. Though BHEL’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 BHEL’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of BHEL’s returns. See our latest analysis for Bharat Heavy Electricals
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.01 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
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 Bharat Heavy Electricals, which is 15.11%. This means Bharat Heavy Electricals’s returns actually do not cover its own cost of equity, with a discrepancy of -13.75%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates 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:
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 reveals how much revenue can be generated from Bharat Heavy Electricals’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Bharat Heavy Electricals’s historic debt-to-equity ratio. Currently Bharat Heavy Electricals has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why Bharat Heavy Electricals’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Bharat Heavy Electricals’s ROE is underwhelming relative to the industry average, and its returns were also not strong 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 Bharat Heavy Electricals, I’ve put together three fundamental aspects you should further examine:
- 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 Bharat Heavy Electricals 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 Bharat Heavy Electricals is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Bharat Heavy Electricals? 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 pass 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.