August 23, 2020

Return on Equity (ROE) Demystified

By Roy

Definition:

Return on Equity (ROE) is the measure of a company’s annual return (net income) divided by the value of its total shareholders’ equity, expressed as a percentage. It is a measure that shows how effectively the management of the company is using the investor’s capital.

As an investor, ROE helps me to make my investing decisions. Say, I am in a conundrum whether to invest Rs. 10 lakh in X company or put it in Fixed Deposit (FD) of Y bank. I will simply compare the ROE of X and FD rates of Y. If X ROE > Y FD Rate, I will invest my money in X company. If Y FD Rate > X ROE, I will put my money in Y bank FD.

  • Let me compare Bank FD rate with ROE of a company.

At Year 0, I will not get any interest.

After completion of 1 year, I will get my 10% interest which is Rs. 10.

After completion of 2nd year, I will get 10% interest on Rs. 110, due to compounding and I will earn Rs. 11 as interest.

The same things happen in a company. Here, the earnings get added in Reserves and Reserves is a part of the company’s networth or shareholder’s fund. That’s why ROE acts like a compounder in my invested company.

Equation:

Capital contributed by shareholders, is called Equity capital. Cumulative returns earned by the company over the years, is known as Reserves. It is also owned by shareholders as they are putting their money at stake to earn that return.

So, the Netwoth or Equity of Company is formulated as,

Total Equity or simply Equity or Shareholder’s Fund= Equity capital+ Reserves

Note: Equity and Equity Capital are two different things.

Then the formula of

ROE Scans:

The formula of EPS (Earning Per Share) looks a bit similar. Doesn’t it? EPS is the net profit earned by the company divided by the total number of equity shares. Whereas ROE is the net profit earned by the company divided by the total equity. The unit of EPS is Rs., ROE is shown in percentage terms.

  1. Look at the previous example. If we make ROE as 20, the EPS growth per year will be 20% as we have seen ROE acts as a compounder of earnings. Thus, higher ROE leads to higher growth. Higher ROE of a company compared to its competitor means, the management of the company using their capital more efficiently.
  2. ROE is a good parameter to judge whether to acquire a company or not. ROE by itself is not a good valuation parameter. A company having an ROE of more than 15 is considered to be good.
  3. ROE brings together two parts of the Financial Statements. We get net profit figure from PNL statement and we get Equity from Balance Sheet.
  4. ROE is not an absolute measure so we have to judge it against the industry average. Placing a company against its average industry ROE, will give a clear picture of the competitive advantage of the company against its peers.

What ROE hides:

  1. As Bhagvat Gita says: “Karmanyevadhikaraste Ma Phaleshu Kadachana”. It tells us to concentrate on the work rather than thinking about its outcome. ROE is a bit antithesis to that. It put so much focus on net profit that it fails to recognise the path adopted in order to generate that profit. Here I mean that ROE as a ratio ignores the most important aspect which is called leverage.
  2. Say, a company is taking a loan of Rs. 100 at 8% annual interest and utilising that money to generate an income of Rs. 14. At the end of the year, it has to pay Rs. 8 as interest and it earns Rs. 14 as income. So, his net profit is Rs. 6. He can keep on leveraging his business and keep on earning. ROE does not encompass the debt. As a result, the company’s ROE will keep on rising and then one bad turn of events and the company will go bankrupt.  That’s what high leverages do.
  3. The return on equity ratio can also be skewed by share buybacks. When management repurchases its shares from the marketplace, this reduces the number of outstanding shares. Thus, ROE increases as the denominator shrinks.
  4. Another weakness is that some ROE ratios may exclude intangible assets from shareholders’ equity. Intangible assets are non-monetary items such as goodwill, trademarks, copyrights, and patents. This can make calculations misleading and difficult to compare to other firms that have chosen to include intangible-assets.

ROE should be seen in conjunction with other ratios. Like, ROE with the cost of equity gives a better understanding regarding the firm’s performance. If a company’s cost of equity is 10% and ROE is 15%, it means the company is generating a value of 5% over and above its cost.

DuPont formula:

ROE completely ignores the leverage part of the business. To overcome that we use DuPont formula which divides ROE into 3 essential parts and project ROE as a product of these 3.

DuPont ROE = Net Profit Margin x Asset Turnover x Financial Leverage.

Net Profit/ Sales = Net Profit Margin, Sales/Total Asset = Asset Turnover, Asset/Equity = Financial Leverage

Closing Remarks:

It will be very rude to generalise the market. But as a left thumb rule, the market tends to give higher valuations to companies that have high ROE. Generally, asset-light business models enjoy high ROE and high PE (Price to Earning). As discussed earlier higher ROE gives the impression that every year company’s EPS is going to grow at that rate. So, always look for ROE before investing in any stock. If the ROE of a company is 5%, then it is better to put your money in risk-free bonds than to invest in that company. But ROE should not be looked at individually. It should be analysed from various angles combining with other ratios to make your analysis bulletproof. Let us see few companies which have high ROE:

The above list has been compiled from screener.in