With An ROE Of 11.64%, Has ABB India Limited’s (NSE:ABB) Management Done Well?
ABB India Limited (NSEI:ABB) delivered an ROE of 11.64% over the past 12 months, which is an impressive feat relative to its industry average of 8.93% during the same period. On the surface, this looks fantastic since we know that ABB has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether ABB’s ROE is actually sustainable. See our latest analysis for ABB India
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making 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 ABB India, which is 14.76%. Since ABB India’s return does not cover its cost, with a difference of -3.11%, this means its current use of equity is not efficient and not sustainable. Very simply, ABB India pays more 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. Asset turnover shows how much revenue ABB India can generate with its current 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 financial leverage can artificially inflate ROE, we need to look at how much debt ABB India currently has. Currently ABB India 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. ABB India’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own 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 ABB India, I’ve put together three key factors 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 ABB 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 ABB India is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of ABB 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 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.
