Should You Expect GlaxoSmithkline Pharmaceuticals Limited (NSE:GLAXO) To Continue Delivering An ROE Of 17.05%?
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 GlaxoSmithkline Pharmaceuticals Limited (NSE:GLAXO)’s return fundamentals and stock market performance.
With an ROE of 17.05%, GlaxoSmithkline Pharmaceuticals Limited (NSE:GLAXO) outpaced its own industry which delivered a less exciting 10.69% over the past year. While the impressive ratio tells us that GLAXO has made significant profits from little equity capital, ROE doesn’t tell us if GLAXO has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of GLAXO’s ROE. Check out our latest analysis for GlaxoSmithkline Pharmaceuticals
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 ₹0.17 in earnings from this. 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
ROE is measured against cost of equity in order to determine the efficiency of GlaxoSmithkline Pharmaceuticals’s equity capital deployed. Its cost of equity is 13.55%. Since GlaxoSmithkline Pharmaceuticals’s return covers its cost in excess of 3.50%, its use of equity capital is efficient and likely to be sustainable. Simply put, GlaxoSmithkline Pharmaceuticals pays less 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:
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. The other component, asset turnover, illustrates how much revenue GlaxoSmithkline Pharmaceuticals 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 artificially increased through excessive borrowing, we should check GlaxoSmithkline Pharmaceuticals’s historic debt-to-equity ratio. Currently GlaxoSmithkline Pharmaceuticals has virtually no debt, which means its returns are predominantly driven by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. GlaxoSmithkline Pharmaceuticals’s ROE is impressive relative to the industry average and also covers 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. Although ROE can be a useful metric, it is only a small part of diligent research.
For GlaxoSmithkline Pharmaceuticals, I’ve compiled three relevant 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 GlaxoSmithkline Pharmaceuticals 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 GlaxoSmithkline Pharmaceuticals is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of GlaxoSmithkline Pharmaceuticals? 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.
