To start and run any company require capital. Capital for such business may be obtained using various methods like the partnership, Public partnership via issuing shares, bonds, loans etc. so before considering to be a partner in such business by purchasing equity share you must consider the Return on Equity that company generates from each rupee of capital you invested in that business.
Mathematical interpretation of the company’s financial record involves ratio analysis of various financial aspects. Mathematical interpretation is required to understand past performance and future prospects of any business. These ratios are very useful for understanding company’s performance over the period of time and peer group analysis within the same sector. Please remember Equity analyst uses a matrix of ratio to evaluate the financial performance of any business. So please remember, no single ratio can provide complete details.
Warren Buffet uses a series of fundamental indicators to identify solid companies worth investing in. Some of the key fundamental indicators used by stock analyst are Return on Equity, P/E ratio, Return on Capital Employed, Free cash flow etc.
Before investing your hard-earned money in any stock, you must check the various financial ratio of the company to understand financial strength of the company. By analysing various financial ratios, you can compare the results with other company in same industry before making the final decision to invest.
In this article, we will try to learn one of the important financial ratios to separate the wheat from the chaff. In this series of articles on Fundamental equity analysis, we will try to learn various key performance indicators. I like to warn you before you read further part of article;
Remember, sometimes you may feel company or sector may have a very impressive financial ratio, but it might be seen very less impressive ratio in different industry or sectors.
What is Return on Equity (ROE)?
Return on Equity (ROE) = Net Income/Average Shareholder’s Equity
Net income means Net profit after tax and Average shareholder’s equity (Share Capital + Reserve and Surplus) is derived from the average of shareholders’ equity at the beginning and at the end of the year.
Return on Equity (ROE) is a tool to measure how efficiently the company manages investor’s money in the business to generate a profit. It is a ratio of net profit earned by the company to shareholder’s fund. ROE is called as “Mother of all Ratios” that can be measured from a company’s financial report.
Return on equity (ROE) provides straightforward analysis of how effectively management of the company (Promoter) is in converting shareholder’s fund into profit; it measures the profit returned for each rupee of shareholder’s investment. In other words, the return on equity ratio shows how much the profit each rupee of common stockholders’ equity generates.
ROE is a critical weapon in the investor’s arsenal, as long as it’s properly understood for what it is and how to utilize it.”
By computing Return on Equity you can measure, how profitable company is and how it deploys your money to generate profit for you. Companies with high return on equity enjoy higher valuations.
The Higher ROE means the company is able to generate more money for the same amount invested in the business. In Equity analysis, higher ROE is favourable means that promoter is efficient to employ investor’s money to generate income on the new investment.
A company with a high Return on Equity does a very decent job of translating the capital invested in it into the profit, and a company with a low Return on Equity does a bad job.”
ROE increases if the company is able to reinvest its profit back to its business to generate a higher return on investment. If the company does not choose to invest its retained profit and keeps it in reserve and earned a similar profit in next year than its ROE would decline.
If company’s dividend payout ratio is high, one should understand that future earnings’ growth rate going to be a very less. If the company has faith in own future business and if it can earn the high return on equity than it might prefer to lower dividend payout ratio and deploy the remaining cash into a new project or to expand the business. If on the other hand, if the company feels they do not have any new projects for business expansion than the company may go with higher dividend payout. This enables shareholders to invest this money in some high ROE stocks, rather than increasing idle cash surpluses on the balance sheet.
Let’s take an example to understand in a simple way, if the company generated a profit of Rs. 1000 with shareholder’s equity of 5000 than Return on Equity (ROE) for this company is 1000/5000 = 20%. Suppose company don’t distribute profit as dividend and if company generate same profit next year than ROE will be 1000/ (5000+1000) = 16.6%. To maintain same ROE which was 20% in previous year company needs to generate a profit of Rs. 1200. A declining ROE is warning indicator, but one must identify the correct reason behind falling ROE, sometimes it is due to new investment which is not generating profit same like existing investment.
However, you should keep in mind that like other financial ratios, there is no standard way by which we can define a business with good ROE or a bad ROE. Remember higher ratios are better for selection, but what counts as “good” varies by company, industry, and economic environment. Higher ROE can be the result of high financial leverage used by the company, but too high leverage is sometimes dangerous for company’s future and creditworthiness.
A Company that generates high returns will pay their shareholders handsomely and create sizeable assets for every Rupee invested. These kinds of businesses are typically self-funding and they do not require any kind of debt or equity investment to grow.
Remember, depending upon sector or industries, ratio will look different and hence one must apply different benchmarking standards based on the future outlook of the company and of the sector”
HOW TO CALCULATE RETURN ON EQUITY?
Let’s take an example of some real-life stock to understand how to calculate ROE of any Stock. Please remember stock discuss here are purely for education purpose, Do not consider stock discussed here as a recommendation from Financial Engineer.
Please remember for this article data used are from various websites and it may have slight error. So, we suggest always use data from the annual report. I personally do not rely on data provided by these websites.
An annual report published by the company is a good resource for collecting information about company’s financial position. You can find company’s financial ratio on various websites, some of the website provide readymade results for various financial ratio, however, I suggest please double check these readymade ratios before selecting a stock.
If you are thinking to invest in a company, you want ROE to be high. If a company’s return on equity is low compared to its competitors, it is not utilizing available resources efficiently and could go / be in financial trouble. ROE is valuable information and it only takes a few minutes to calculate, using financial data from company’s financial reports.
I am taking an example of one of the old and famous FMCG Company COLGATE, as you know the company is in oral care products business. Looking at Colgate’s annual report, here is the ten-year financial performance highlight.
Looking above financial performance report, Profit is improved from Rs. 137 Cr. in the year 2005-06 to Rs. 559 Cr. and shareholder’s fund increase to Rs. 770 Cr from Rs. 271 cr. reported in the year 2005-06. In this ten year period, Profit rose almost 4 times and shareholder’s fund rose around 3 times.
Now, let’s take net profit after tax and shareholder’s funds from above report to calculate Return on Equity. As per formula explained above Return on Equity is calculated by taking year’s earnings after tax and dividing them by average shareholder’s fund for that year, remember ROE is expressed as a percentage.
Higher ROE for one year may be due to various reasons as a long-term investor we should not form an opinion to buy shares of the company by calculating ratios for just one year. Long term investor always checks past records. I suggest you should look for more than 10-year trend before the final conclusion. It should not be bad for more than one or two instances.
This gives a better idea of the company’s average performance over a period of time. This would give a reasonable assurance of the rate of return that the company is capable of generating. This will help you to understand whether the business is worthy of investment or not. So based on above information I have calculated ROE just by using a simple formula in excel sheet.
For the Year 2014-15, Colgate’s Return on Equity is 81.6%. This means Colgate created an asset of 81.6 Rs from every 100 Rs originally invested. Look at the ROE of Colgate, Last ten year average ROE is 103%, last five year and the three-year average is 102% and 96% respectively.
Please check the highlighted figures in the picture, Colgate slashed the face value of its share by 90% from Rs 10 to Re 1 in the year 2007. Colgate returned Rs 122.40 crores from its equity capital of Rs 136 crores to shareholders, reducing the base to just Rs 13.6 Crores. by this move, the number of shares issued and pattern of shareholding has remained unchanged.
See the effect of Reduction in shareholder’s capital on ROE, Return On Equity bumped up from 58% to 104% just because of reduction in Equity capital. This move also indicates the intention of Colgate, surplus money which is not deployed in business who is generating 58% return on Equity and if it is deployed in low yield investment like fixed deposit, will typically lower ROE of the company.
So, by this example you must know that shareholder’s equity is denominator in ROE calculation, means if a value of shareholder’s fund or Equity goes down, ROE goes up. Thus, share buyback can falsely boost ROE. This is the reason you should check the trend of ROE over 5 or 10 year periods. It can be artificially influenced by the promoters to boost the share price in the market, using debt to reduce share capital. This will help them to show improvement in ROE of the company even if profit remains constant.
Is this ROE Impressive? Let’s Look at Competition.
As I said earlier, depending upon the industry or sector, the ratio will look different so to check whether it is really high I compared it with its peer companies.
Colgate’s share is part of CNX FMCG Companies indices in National Stock Exchange (NSE), CNX FMCG indices represent FMCG sector in NSE, and Top 10 constituents by weightage are,
Let’s have a look at its competitor’s ROE performance for the period of last ten, five and three years. I am removing United Spirit and ITC from ROE calculation because of their nature of business can’t be compared to Colgate, former having majority of income from liquor business and later having income from cigarette business. As I said to get the true picture one should compare apple with apple, not with orange.
Now looking at above results, no further explanation is required for identifying high ROE stock. Please remember ROE is not the only indicator for stock selection. Have you noticed the ROE improvement in Hind Unilever, Britannia and Emami?
You must have a question in your mind, what are the drawbacks of using ROE for stock selection? ROE doesn’t tell us whether company having access amount of debt or not. Keep in mind, shareholder’s equity (which is denominator in ROE formula) is assets minus liabilities, which comprise short term and long term debt. So, if the debt is more than equity, it will result in higher ROE. This drawback highlights the need of analysing the trends of other underlying instruments which may have a positive or negative effect on ROE.
The DuPont formula to Calculate Return on Equity
The DuPont formula has a the solution for the concern raised above by breaking down the return on equity and allowing you to see which factors are helping or hurting ROE of the company. DuPont Formula will help you to decide whether promoters are generating value for shareholders effectively or not. I suggest you must use DuPont formula once you finalized your stock list using first ROE formula to save some time.
Please keep in mind that high ROE might not show the true picture about company’s operation. The reason is simply taking huge debt company may exhibit a strong ROE. Any business which is funding growth through borrowings eventually leads to higher interest burden which may affect profitability in the long run.
Due to these limitations, it is required to identify, what is fuelling the returns. DuPont model helps you to deconstruct the ROE matrix into distinct parts, which helps you to identify how company achieving its ROE – by increasing profit margin over the period or by using leverage or due to higher asset turnover. By using DuPont analysis the ROE is calculated as follows;
Three Step DuPont model capture the efficiency of company’s Promoters to generate profit using net profit margin (Net Profit Margin = Net profit or Net Income / Sales), utilisation of assets (Asset turnover= Sales/Total Assets) and using leverage (Equity Multiplier = Total Assets/Shareholder’s Equity).
As an Investor, I prefer to put my money in the company which is able to generate the High ROE by improving its net profit margin or optimum utilisation of Assets or both.
The Net Profit Margin shows how much earnings the company generates from each rupee of sales. A higher or increasing profit margin suggests its pricing power and competitive advantages over its peers. High-profit margins suggest company enjoying Moat. Because of product’s brand Image, Company enjoy the pricing power and can sell products at a higher margin compare to its peer companies. Because company having moat advantage, the company can eliminate competition from any newcomers by lowering pricing or improving customer satisfaction by improving product or / and service quality.
Asset Turnover of the company measures how much sales it generates from each rupee of assets. Generating more sales on fewer assets implies that the company is not required to invest more funds to purchase assets in an effort to generate revenues. It essentially indicates the management’s efficiency in utilising its existing assets to drive sales.
Coming to the last part of DuPont formula, if the company is using excessive Leverage (Equity Multiplier) to boost company’s ROE than, it could be an alarming sign. If the company already have high debt and if company continue to increase debt then it may increase the risk of credit default or we can say the company may go bankrupt.
Return on Equity has three primary drivers, Better turnover (sales), higher margins and high level of debt and each of these can lead to higher ROE. Return on Equity is good performance indicator, but it does not tell you what are the other factors which are helping or hurting the performance of your company.
Factors that affect Return on Equity.
Generally company using buyback option to raise own shareholdings in the company if they are confident in future earnings but another reason a company might look for share buyback is just to improve company’s financial ratio where investor like you and me are heavily focused on ratios. But if company’s motive for doing buyback is to create wealth for investors, then improvement in various financial ratios is the by-product of management’s decision.
Let’s have a look on how buyback improves Return On Equity (ROE); first of all, the buyback will reduce the number of outstanding shares. Moreover, the buyback will reduce the shareholder’s reserve from the balance sheet. As a result Return on Equity will increase because of less outstanding equity and reserve. In general equity analyst and market views higher ROE as a positive signal.
Suppose a company having total equity of 100 shares and it offers the buyback of 40 shares out of 100 outstanding shares at the rate of Rs. 100 per share. The company will utilize its cash reserve to for buyback. Below is the calculation showing how the financial indicators will change by this move.
See the effect of Buyback on ROE, without increasing profit ROE increase to 47% from 10%. Please note, stock buyback does not change net profit but decreases shareholder’s capital and reserve after the buyback. Share buyback also helps to improve the other financial ratios.
For Example buyback will decrease P/E ratio, when it comes to P/E ratio lower is better. Fewer share + same earnings = higher earnings per share. The formula for P/E ratio is Current share price/Earnings per share (EPS). So if I use P/E ratio as a measure of value than the company is less expensive than it was prior to the buyback, in fact, is there is no change in earnings.
Likewise, if the company increases the number of shares instead of increasing debt for business expansion, Return on Equity will be affected. Issuing new shares to the investor will increase the shareholder’s capital. So, without any impact on net profit ROE will decline because of the higher value of shareholder’s equity.
Irregular Profit Activities
Some companies invest in forward contracting to hedge currency risk. If any additional profit generated from this investment will improve company’s bottom line, which will result in improvement in ROE. If investment turns into losses will reduce net profit and ROE.
The sale of Plant, Equipment or any assets in given period also boost revenue, improve the bottom line and ROE. Same way irregular expenses like one-time legal fees or fine in given period of time will lower the profit and subsequently it will reduce ROE.
POINTS TO REMEMBER
- Financial Ratios are very useful to check and understand the company’s performance over the period of time.
- With the help of Small mathematical calculation, you can understand financial strength of the company and make the comparison with other companies in the same sector.
- Always compare financial ratio within same sector company, remember ROE of 30 seems less impressive for FMCG sector, but it might be seen more impressive in Banking sector.
- Return on equity provides straightforward analysis of management’s capability in profit generation.
- Higher ROE is better, but check what is fuelling ROE.
- A declining ROE is warning indicator, you should identify the correct reason behind falling ROE before making any decision.
- Due to various reasons, ROE can be higher for one year. always check ROE trend for minimum 5 years.
- A company with high ROE over the period of 5 years must have reduced the debt during the same period. So ideally the company who is generating high ROE may have almost nil or low debt.
- Simple ROE formula doesn’t tell about the company having how much amount of debt, use it to eliminate junk during stock screening.
- Use DuPont analysis to check what is fuelling ROE, is it due to improved profit margin or due to leverage or due to asset utilisation?
- Share buyback will improve ROE and increasing share capital will reduce it.
Please share your views and query by comments. Let me know if you find some good stock with high ROE.