ROE means the returns on equity. By equity we mean the shareholder’s equity, also known as net worth. Mathematically, ROE is nothing but net profit after tax divided by shareholder’s equity. When we define net profit and shareholder’s equity, we have to understand what it includes and excludes.  The net profit excludes dividends paid to the preferred shareholders, but includes the dividends paid to the common shareholders. We take net profit after tax because this is the money available to the common shareholders. Shareholder’s equity is assets minus the liabilities.

As with net profit calculation, the shareholder’s equity in ROE also excludes preferred shareholder’s portion. So, shareholder’s equity in ROE means common shareholder’s equity only.

ROE = Net profit / Shareholder’s equity

How to calculate ROE:

Analysts basically calculate it in two different ways. Few like to take average shareholder’s equity as base which is an average of shareholder’s equity for the last year and the current year.  Some use shareholder’s equity for the current year only as the base. Those analyst’s who use average shareholder’s equity say that since profit accrues to the firm over the years while the shareholder’s equity is calculated at the end of the year, it is better to take the average shareholder’s equity.

Mathematically ROE is:

ROE = Net profit / Shareholder’s equity

Or

ROE = Net profit / ((Last year’s shareholder’s equity + Current year shareholder’s equity) / 2)

We will use 1st way to calculate ROE to make things easier.

Example: XYZ Ltd – data from FY2010 to FY2014

The data is taken from www.moneycontrol.com. Here is the balance sheet for the last 5 years of a dummy company XYZ Ltd. We are showing the source of funds only to avoid too much of the data here.

Let’s take a look at Income Statement for the last 5 years. Here again we will show the partial income statement to avoid too much of the data.

Let’s take out the relevant data for our analysis:

Let’s calculate ROE based on this data:

The ROE is good for this company. Though the readers should not take decision to trade based solely on this information and should analyse other fundamental parameters too.

Meaning of ROE

High ROE is certainly a good thing. It simply means the company is earning good returns for the common shareholders. However, only this data is not enough. ROE should not be seen in isolation, but as a part (though a very vital part) of the entire fundamental analysis.

For example, a high debt has the tendency to inflate the ROE. The high debt capital structure works well as long as the market condition is good and the business is growing, but any slowdown in business will impact the companies adversely that have high ROE and high debt.

Let’s take an example: Look at the company data below: (The data shown in tables use basic data, sanitized to convey the meaning of the topic at hand)

The ROE of the firm having high debt is 15.6% compared to the firm with low debt, which has a ROE of 10.20%. See how the ROE is more for the firm with higher debt even though the profit is same in both the cases.

As long as the company does well and the market is growing, this will keep investors happy. As soon as a slowdown hits, no matter how small, this will impact the returns in a big way. Let’s assume that the revenue falls by 10% because of a general slump in the market. Look at the altered situation now:

The company with high debt has new ROE of 3.6% compared to the firm with low debt, which has new ROE of 4.2%. The reduction in ROE for the high debt firm is whopping 12%, while the same is 6% for the low debt firm.

If there is a further impact on revenue by 5%-10%, the ROE of high debt firm A will be negative. This is just an example to show how reliance on ROE only can be misleading.

A classic example of what high debt capital structure and ROE means in adverse market conditions is Kingfisher (see the graph below). We all know where is Kingfisher today:

DuPont Formula:

Another way to look at ROE is through DuPont formula. According to DuPont formula

ROE = (Net profit / Sales) * (Sales / Assets) * (Assets / Equity) = Net profit / Equity

This implies,

ROE = Profit Margin * Assets turnover * Equity multiplier

High ROE as a result of the first two parameters is considered good while because of the last parameter is considered bad for the reasons shown in above mentioned example.

How to use ROE for analysis

Here are some general guidelines on how ROE should be interpreted while taking investment decisions:

1. ROE should be one important criteria, but it should always be studied in conjunction with other important data such as debt, taxes, and interests.
2. If ROE is less than the safe rate of returns, such as bank deposit, Government bonds, it means the management is poor or the performance of the company is bad.
3. An ROE less than the industry ROE is bad. It shows that the company is below average in performance.

As explained earlier, if other parameters are reasonably fine, a high ROE is always preferable. We should mainly look at debt also when we study ROE.

Secondly, ROE measures accounting profit and its relationship with shareholder’s equity. The accounting profit leaves much room for exploitation. We must look at cash flow to ensure that the accounting profit converts to real cash flow and not into account receivables (where sometimes companies dump the goods to their customer on credit without worrying about whether the customer can pay for it).

Thirdly, we should also look at the typical ROE in an industry. For example, the banking sector has a typical ROE of 10%-20%, while ROE for IT sector may vary from 15%-40%. Now if a company in IT sector earns ROE of 15%, while the industry average is 30%, the investor needs to be careful or explore further. When we study companies’ ROE, we should make sure that we are comparing ROE of the firm under study with the right firm in the same industry.

Additionally, ROE gives important information about the growth rate of the company. The growth rate of a company is defined as ROE * (1-payout ratio). What this means that a company cannot grow beyond the ROE unless it takes more debt.

Conclusion

ROE or Return on Equity is a very important indicator of a company’s performance, its management’s competence, and industry position. It is important to calculate ROE through DuPont model to have the right perspective into high ROE of the given firm.

If you want to analyse ROE or Return on Equity of various Indian companies or want to compare ROE of two companies, please click here.

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