There is almost a unanimous agreement in investment community that RoE is an important indicator of health of a company, High sustainable ROE implies sustainable competitive advantages and hence investment attractiveness of the company

Sustainable is a key word here so always execute ROE analysis for at least 5 years if not 10 years to arrive at a conclusion

DuPont comes in handy to break down ROE, I will not go into details of DuPont , you can read this article to get yourselves accustomed to DuPont

You can use Tankrich Valuation Tool to do DuPont analysis in 5 mins, post analysis how do you dissect RoE ?

This will be largely dependent on how familiar you are with operations of the company and industry, We will take a case today and see if we can put together a generic framework for dissecting RoE

Friends this is going to be a long post so take out your pen, paper, food and time and lets dig in. The company that we will use as case is Ajanta Pharma

The RoE for last 5 years has been ..


Fantastic improving from 16% to 41%

The frame-work that we are going to use to dissect RoE is called 3W model

W -What factors are driving RoE ?

W – Why those factors are behaving in such manner ?

W- Whether those factors would sustain in near future ?

For Ajanta Pharma,

What factors are driving RoE ?

This is the easiest W to answer, Expansion in ROE is due to increase in net profit margin (NPM) and higher asset turnover this is accompanied by substantial reduction in equity multiplier, Clearly the growth is internally funded

Why those factors are behaving in such manner ?

The second W is difficult to answer and requires a lot of analysis and deliberations, we will try and understand each lever of DuPont one by one, first about NPM – here are last five years numbers from P&L account


This is partial picture the complete picture can be seen here


The Net profit Margin has zoomed from 6.69% to 19.90% almost a 3-fold jump, Let break down the contributors to it

Factors that have increased NPM

COGS ( 863 basis points improvement over last 5 years)

COGS has reduced considerably from 39.95% to 31.32%, a huge component of COGS for Ajanta is cost towards API (raw materials) See 2014 annual report extract


API are portions of drug, which are active, In simple terms they are chemicals combined together to make a drug (Tablets, Capsules, Ointment etc.) Ajanta pharma has been able to keep consistently low COGS (Corollary – The gross margin is expanding)

Improvement in gross margins indicates – Pricing power, After 2010 annual report Ajanta pharma stopped reporting units of sales but have a look at 2009 and 2010 numbers, Do you see a 20% steep rise in price per tablet ? That’s pricing power for you!


Indirectly management indicated below

In 2013 management indicated 70-75% of the domestic sales are through prescriptions and the rest are tender based sales. The company has reduced its exposure to tender based sales over years as a result of which EBITDA margins have expanded.

In 2014 annual report management indicated as result of enhanced economies-of-scale, procedural improvements and better negotiation the margins have expanded

Finance cost reduced to 0.74% of sales in 2014 from 6.90% in 2009 (615 basis points reduction over last 5 years)

This is far more easier to understand if we compare debt levels of the company, The long term borrowings reduced from INR 200 crore to INR 51 crore

Other expenses ( 440 basis improvement over last five years)

Again it is very difficult to pin point where  company is saving but looking at key heads while analysing annual reports of last five years, Selling expenses have reduced as a percentage of other expenses. Again we have rely on management commentary that economies of scale are bringing benefits

Turning our attention to factors that have reduced NPM

Tax expenses contribution ( increased 687 basis points over last 5 years)

The tax rate for company has progressively increased to corporate tax rate % see below


Also Minimum Alternate Tax has become charge instead of entitlement in recent years


This is what management reported through 2014 annual report

During the year, income tax provision has seen sharp increase as all carry forward losses were exhausted and a liability of 15.75 crs. was provided towards previous years

The other key expense components depreciation and employee expenses have remained largely stable and increased with sales between 2009 and 2014

Alright now let’s focus our attention to Asset turn over

The asset turnover has improved from 1 to almost 1.71 over last 5 years, The asset turnover increases broadly when firm

Classifies operating assets as leases – This is an accounting gimmick and if a firm has significant operating leases they should be treated as fixed assets, For Ajanta Pharma operating leases are not significant compared to scale of operations


Accelerate Account receivables and better inventory management – In such case growth in sales should outpace growth in current assets. For Ajanta

Sales CAGR for last 5 years is 30.32% however current assets have grown by 17 % indicating better AR and inventory management

Has scale advantages – In such case growth in sales should outpace growth in fixed assets, as assets are better utlised ,Sales CAGR for last 5 years is 30.32% however fixed assets have grown by 23 % indicating better scale advantages to the firm


Finally the last component in RoE is equity multiplier

In Ajanta’s case the equity multiplier has been negative factor to RoE increase, The constant reduction of debt has reduced this lever for RoE

Now I will come to last W of RoE dissection

Whether those factors would sustain in near future ?

Alright can Ajanta pharma sustain this RoE levels ?

To answer this we need to make an educated guess for all key parameters discussed above

Gross margins – Pricing power – The new product launches mainly first time launches have helped Ajanta maintain pricing power, See below chart . The gross margin is impressive and needs to be reviewed on yearly basis. Nothing suggest that gross margins would dive below current levels


Finance cost – The company is practically debt free, So we should not see any spike in finance cost

Tax Expense – The current tax rate is close to corporate tax rate, however 100 to 200 basis points hit to NPM is not ruled out in next few years

Asset turnover – Huge leverage on this account in not expected until unless company’s outsources manufacturing (not a norm in Indian pharma)

In conclusion



We will live another day to see whether company proves us right or wrong

Hope you liked this 3W RoE dissection model. Do you want to analyse a company like this ?How else do you analyse RoE dissection ?

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