ROE: Why It is One of the Most Important Ratios

The Fundamentals

ROE is a very significant profitability ratio that is considered closely for monitoring the performance of an entity. This ratio figures amongst the most used by analysts as well as investors in evaluating stocks and forecasting their performances. It is basically described as return on the investment of shareholders. In simple equation it can be represented as follows:

ROE= Net Income/ Shareholder’s equity (Capital) * 100

Where,
Net Income = Net profit after Interest, tax and dividend paid to preference shareholders
Equity here includes reserves and surpluses whereas preference shareholding is excluded. Returns denote pure earnings that can be allocated to “equity” shareholders exclusively.
In simple words, an ROE of 15% would mean a return of 15 cents per dollar invested by shareholders.

DuPont Analysis of ROE

There is more in-depth breakdown of this ratio which combines Net profit margin, Asset turnover and Equity multiplier in ROE which was devised by DuPont and hence the name. The breakdown helps in giving a well rounded understanding of this ratio and can be reproduced as follows:

ROE= (Net Profit/ Sales) X (Sales/ Assets) X (Assets/ Equity)

Components:

The first component Net Profit margin indicates the profit that an entity derives out of its total revenue. Again simply put, it shows how much profit is derived out of revenue flow. A 15% net profit margin indicates that in a dollar’s sale, the net profit is 15 cents.

Second component also known as Asset turnover ratio is an indicator of how efficiently a company puts its assets to use for revenue generation. It indicates the sales generated per dollar of amount invested in assets. More the ratio better is the utilisation.

The third and last ratio of equity multiplier shows how well a company is leveraged. This essentially points at the debts used for financing the entity in proportion to the shareholder’s equity. Higher ratio would mean higher debt though not unfavourable in all cases as we will discuss later here.

When you do simple Math, numerator and denominator of Assets and Sales cancel each other out as follows:

ROE= (Net Profit/ Sales) X (Sales/ Assets) X (Assets/ Equity)
And we are left with:   ROE = Net Profit/ Equity - The equation we began with in the first place.

The DuPont breakdown goes on to show why ROE is such a critical ratio for analysts and investors alike. It basically is combination of three ratios that reflect overall profitability and efficiency of a company. This breakdown also shows the bearing of six factors on ROE instead of the usual two that we assume are the beginning and end of it.

ROE as a proxy for Competitive Advantage:

Consistently High RoE figures do indicate that the company has a moat. As seen above in the Dupont breakdown of RoE, a company can have a high RoE either because it is able to sell its goods/services at a high margin or because  increase its returns by either selling its products at a high rate. Only the third option is undesirable i.e having a high leverage which would mean high indebtedness . Remember, we said a consistently high levels of RoE to be construed as an evidence of a moat. This is because the denominator of this ratio includes shareholders equity which in turn consists of   share capital plus retained earnings (also called reserves and surplus)

Share holder's equity= Share capital + Retained earnings

Now as the company generates higher returns on equity, the profits are added to the retained earnings. So the denominator of ROE keeps increasing and so either the company has to keep showing growth in its profits or find ways to reduce the denominator. The company can do that by either paying higher dividends or buying back shares- both strategies lead to gains for shareholders.

Difference between ROE and ROC

Though at the outset, ROE and ROC look very similar but at the core they are very different from each other. ROE measure returns net of preference shareholders’ dividends on denominator of pure equity shareholding. But ROC has a wider denominator which includes the aforementioned dividends as well as debt because that is total capital employed. Let us look at the two equations:

Let us give a small example for differentiating between ROE and ROC:
From the books of ABC Corp:
Equity Shareholding: \$ 100,000
Preference Shareholding : \$ 5000
Long term Bank Borrowings: \$ 30,000
Operating profit after tax (before dividends/interest): \$ 15,000
Dividend to preference shareholders and interest on borrowings: \$ 2000

ROE can be way higher than ROC if the debt and preference shareholding is optimised because the base for computing ROE is much smaller and the adjustment to numerator is only in term of dividends and taxes. Though an entity does not have a direct control on taxes but it is the interest and dividend component that a company has a bearing on.

An everyday example

Let us explain this entire equation with a simple example: Mr. A buys a house in 2015 January as per details as follows:
Cost of the house: \$ 20,000
Own savings : \$ 10,000
Bank borrowings: \$ 10,000 @10% per annum
On 31st December’2015, appreciation in the value of house: \$ 4000
In view of the above let us use ROE basics and apply them on Mr. A’s investment.

Let us now further break it down into three components as per DuPont Analysis:
Assumptions: Since there is no Sale, the figure of \$23,000 is assumed to be the sale since it is the price that Mr. A would fetch.
Return as explained earlier: \$ 3000
Equity: \$ 10,000
Debt: \$10,000
Asset: \$20,000 (House cost \$ 20,000; alternatively equity \$ 10,000 + debt \$ 10,000)
ROE= ((3000/23000) X (23,000/20,000) X (20,000/10,000))*100= 30%

Importance of leverage

Significance of leverage is quite evident as one can see that the ROE has fallen drastically to 17% from the earlier 30% by lowering the debt portion from 50% to 25% of the total investment. This means that cost of servicing debt is less than the equity. On the other hand, say 75% of the investment was met by borrowings; the equation would change as follows:

This again reiterates that servicing debt is a cheaper option and this is why return is higher.

Important note: In this case we are looking at one transaction in isolation. Heavy indebtedness is not an ideal strategy as with time the mounting debts and interest thereon vis-à-vis lack of appreciation in the asset value would bring down the ROE while impacting solvency negatively. In a real world, if a company is highly leveraged, then stockholders would show less faith in it as it indicates lack of internal cash generation to support its operations.

One must understand that returns / profits play an important role when computing ROE. Only higher earnings combined with higher efficiency can give an impressive and sustainable ROE which makes it a favourite amongst analysts.

Summary

Significance of ROE:
•    Identification of high growth companies
•    High ROE is an indicator of healthy internal cash flows
•    Aids investment decisions for an average investor
•    Facilitates benchmarking in industry and performance comparison between entities

Notes & limitations:

• Cases where Capital has undergone change due to buybacks or fresh issue during the financial year, considering weighted average of equity is more meaningful.
• Buybacks can affect the ROE by shooting it up tremendously; in such cases look at the earnings per share (EPS) which should have gone up on account of shrinking of base.
• ROE cannot be used as a benchmark across industries. It can be part of evaluation metrics only in case of entities within a     common industry or in cases where benchmarking across different industries is the goal.