DIY Investing . How to use DuPont analysis to understand RoE

The return on equity (RoE) is one of the key metrics to identify stocks.

A simple way of calculating it, is by dividing the net profit by shareholders’ equity. The DuPont analysis takes into consideration other key financial metrics that drive the RoE and helps investors make an informed decision. As per DuPont analysis, RoE is equal to net profit margin *asset turnover * financial leverage.

The criteria

We considered only Nifty 200 companies (excluding BFSI) for the purpose of this analysis.

Looking at the components of the DuPont analysis alone may not be the right way to pick a company but it is a good tool for comparing companies in the same industry. The metrics considered here vary from industry to industry. Especially, cyclicals for which economic phases play an important role in financial performance and can distort the ratios. Thus, your research using DuPont analysis should be limited to companies within the same industry.

Here, we look at shortlisted companies that project a linear trend in the key metrics mentioned above in five years up to FY20, as per data sourced from the Capitaline database. The stock performance mentioned below is for the five-year period, till-date.

Rising margins

Net profit margin is one of the profitability ratios. Higher margins with steady revenues will have a positive impact on the RoE. Out of the selected universe, seven companies posted an increase in net profit margins during FY16 and FY20.

Pfizer, a pharmaceutical company, has improved its profit margins from 15.16 per cent in FY16 to 23.66 per cent in FY20. Despite stagnant revenue growth, the margins increased consistently with new product launches, volume growth in top brands and intermittent price hikes. The stock price of the company went up by 115 per cent in the last five years.

Hindustan Unilever, improved margins from 13.19 per cent in FY16 to 17.2 per cent in FY20. Till date, the stock has gained about 194 per cent in the five-year period.

Ipca Labaratories, with its focus on branded generics and active pharmaceutical ingredients (APIs), improved its margins from 3.2 per cent in FY16 to 13.04 per cent in FY20. No wonder, the company’s stock price went up by 206 per cent in the last five years.

Meanwhile, Escorts operating in the capital goods industry has grown better than the industry in the last few years with margins rising from 2.04 per cent in FY16 to 8.13 per cent in FY20. The stock price of the company too skyrocketed by 855 per cent in the five-year period till date. The other companies include Endurance Technologies, Crompton Greaves Consumer Electricals and Gujarat Gas. Aided by better profitability, the share prices of these companies went up by 120-220 per cent in the last five years.

Better asset turnover

The asset turnover ratio (sales/total assets) measures how efficiently a company uses its assets to generate revenue and thus resultant higher return on equity. We picked companies that have been reporting an increasing trend in the asset turnover ratio (ATR) in each of the last five years.

Three companies made the cut and belong to either power or gas transmission industries. They are - Power Grid, Gujarat State Petronet and Adani Transmission. Except for Adani Transmission, the other companies have had an unimpressive performance in the stock market. This metric should not be seen in isolation but together with how costs are controlled, margins are maintained and other factors. Note that, a normal ATR will vary across industries. Usually, a capital intensive company’s ATR will be much lower than a services company.

Low financial leverage

Financial leverage calculated by (total assets/shareholders’ equity), or the equity multiplier, provides an indirect analysis of a company's use of debt to finance its assets.

Lower the leverage ratio, lower is the utilisation of debt to fund the company’s assets. On filtering companies that have been striving to reduce the leverage ratio, we get 15 companies out of the selected 200.

Out of these, Ipca Labs, Endurance Technologies and Crompton Greaves Consumer Electricals, made the cut.

Unlike for the first two companies, in case of Crompton Greaves, the RoE has been declining -- from about 76 per cent in FY17 to 39 per cent in FY20 -- despite a rise in profit margins and low financial leverage. This could be due to the inefficient capital utilisation reflected in the fall in ATR from 3.3 times in FY17 to 2.7 times in FY20.

Companies with higher RoE and also higher financial leverage should also be analysed closely. Leverage may optimise the overall cost of equity, but too much debt will dent the company in long-run. For instance, take Indus Towers. From FY16 to FY20, the company’s RoE increased from 11.19 per cent to 23.5 per cent. During the same period, the financial leverage also grew from 1.06 to 1.37 times. This suggests that a part of increase in RoE was due to leverage and has become bit riskier than earlier.

(This is a free article from the BusinessLine premium Portfolio segment. For more such content, please subscribe to The Hindu BusinessLine online. )

COMMENT NOW