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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 companys 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 companys 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;

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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 Shareholders Equity

Net income means Net profit after tax and Average shareholders 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
investors money in the business to generate a profit. It is a ratio of net profit earned
by the company to shareholders fund. ROE is called as Mother of all Ratios that
can be measured from a companys financial report.

Return on equity provides straightforward analysis of how effectively management of

the company (Promoter) is in converting shareholders fund into profit; it measures
the profit returned for each rupee of shareholders 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 investors arsenal, as long as its 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
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means that promoter is efficient to employ investors 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 companys 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 payout. This enables shareholders to invest this money in some high ROE stocks, rather
than increasing idle cash surpluses on the balance sheet.

Lets take an example to understand in a simple way, if the company generated a

profit of Rs. 1000 with shareholders equity of 5000 than Return on Equity for this
company is 1000/5000 = 20%. Suppose company dont 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
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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 companys 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?

Lets 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 companys financial position. You can find companys 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 companys
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
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information and it only takes a few minutes to calculate, using financial data from
companys 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
Colgates 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 shareholders 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 shareholders fund rose around 3 times.

Now, lets take net profit after tax and shareholders funds from above report to
calculate Return on Equity. As per formula explained above Return on Equity is
calculated by taking years earnings after tax and dividing them by average
shareholders fund for that year, remember ROE is expressed as a percentage.

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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 companys 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, Colgates 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 shareholders 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
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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 shareholders equity is denominator in ROE
calculation, means if a value of shareholders 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? LETS 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.

Colgates 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,

Lets have a look on its competitors ROE performance for the period of last ten, five
and three years. I am removing United Spirit and ITC from ROE calculation because
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of their nature of business cant 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 doesnt tell us whether company having access amount of
debt or not. Keep in mind, shareholders 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

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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 companys
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 companys 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/Shareholders 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
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enjoying Moat. Because of products 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 managements 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 companys 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 companys financial ratio where investor like you
and me are heavily focused on ratios. But if companys motive for doing buyback is
to create wealth for investors, then improvement in various financial ratios is the byproduct of managements decision.
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Lets 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
shareholders 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
shareholders 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

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investor will increase the shareholders capital. So, without any impact on net profit
ROE will decline because of the higher value of shareholders equity.

IRREGULAR PROFIT ACTIVITIES

Some companies invest in forward contracting to hedge currency risk. If any
additional profit generated from this investment will improve companys 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 companys
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 managements 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.

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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 doesnt 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

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