return on equity

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http://www.financialengineer.in/ultimate-guide-on-return-on-equity/

ULTIMATE GUIDE TO RETURN ON EQUITY

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 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 pay-out ratio is high, one should understand that future

earnings’ growth rate going to be a very less. If the company has faith on own future

business and if it can earn high return on equity than it might prefer to lower dividend

pay-out 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 pay-

out. 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 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 website provides 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.

http://www.colgate.co.in/Colgate/IN/Corp_v2/Investor/FinancialReports/annual-report-2014-15.pdf

http://www.financialengineer.in/wp-content/uploads/2015/10/ten-year-performance.png?csspreview=true



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 about 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, ROE 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

http://www.colgate.co.in/Colgate/IN/Corp/InvestorRelations/Shareholders.pdf

http://www.financialengineer.in/wp-content/uploads/2015/10/10-Year-ROE-Performance-of-Colgate-Share.png?csspreview=true



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 on 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

http://www.nseindia.com/content/indices/ind_cnx_FMCG.pdf

http://www.financialengineer.in/wp-content/uploads/2015/10/NSE-FMCG-Index-Top-10-constituents-by-Weightage.png?csspreview=true



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.

(Click on image to open image in new tab)

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

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

http://www.financialengineer.in/wp-content/uploads/2015/10/NSE-FMCG-Return-on-Equity.png?csspreview=true



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

http://www.financialengineer.in/wp-content/uploads/2015/10/DuPont-Formula.png?csspreview=true



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.

SHARE BUYBACK

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 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

http://www.financialengineer.in/wp-content/uploads/2015/10/share-Buyback.png?csspreview=true



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 boosts 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.

Thanks for reading.

Regards,

Paresh Patel


return on equity

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