Return on Equity (RoE) is an accounting ratio used primarily by Value Investors world-over. The interpretation of this ratio is fairly simple: It is the ratio of Net Income earned from a Business to the Shareholder's Equity for a given accounting period. Let us see how to interpret this ratio and apply it for taking investment decisions.
Higher the Return on Equity, the better it is. Generally, it so happens that during the course of many years, that a successful Business is accruing profits,the reserves base becomes high and consequently the Return on Equity declines. Let us look at RoE as a composite of 3 different accounting ratios. This formula below is called as DuPont Analysis.
RoE = (Net profit Margin) * (Asset turnover) * (Financial Leverage)
= (Net Profit / Sales) * (Sales/Assets) * (Assets/Equity)
You see how the denominator cancels with the subsequent numerator and we are left with Net Profit/Equity which is nothing but our original expression for return on Equity. Then what is the need to represent this simple ratio in a fairly complex equation? Well, the 3 constituent terms have their own significance. Let us look at each one individually:
a. Net Profit margin: This is simply the net profit as a ratio of total Sales for a given accounting period. The higher the Net Profit margin, the better it is. A higher net profit margin is a result of operational and financial efficiency that an organisation exhibits over the course of the year.
b. Asset turnover: This is the accounting ratio of Net Sales to Average total assets for a given accounting period. Average total assets are calculated by taking a simple average of assets at the start of an accounting period and assets at the end of that accounting period. A higher asset turnover ratio signifies that the company in question is using its assets efficiently. Likewise a lower ratio indicates the opposite.
c. Financial Leverage: The ratio of average total assets to the shareholder's equity is termed as financial leverage. In simple terms it indicates how much is the asset owned by the company for 1 unit of owner's equity. The higher this ratio, it indicates that the company is dependent on external sources of funding to create its assets. This external sources of funds is nothing else but the liability that the company owes to the external financing entity. As you must have noticed, the financial leverage is a multiplier that does the job of increasing the RoE for Debt financed companies. Higher the financial leverage that a company operates at, the higher will be its RoE relative to a company with no leverage.
Combined interpretation of all three ratios:
As you can see, the simple multiplication of the above three ratios gives us the Return on Equity. However, it is important to understand the role that financial leverage plays in deriving the RoE. If the RoE ratio is amplified by the financial leverage, it means that the company has a scope for improving its core profitability and turnover ratios. What it is doing good is borrowing funds and using them efficiently to generate a higher Return for its shareholders. Financial leverage is not bad, infact it is desirable to an extent. However, it is a common belief that financial leverage must amplify the RoE over and above the expected RoE without financial leverage.
How much RoE is enough?
This is a subjective question and depends on the industry that we are talking about. However, RoE figure consistently between 25-30 percent is considered pretty good. When analysing RoE, it is important to note that RoE needs to be observed in context to the figures for the past years and not just the standalone number for a particular year. For the benefits of readers, I have decided to give the top 5 companies in India with highest RoE and I will compare it with the technological giants in the USA (Facebook, Amazon, Apple, Netflix, Google)
Let is see how this compares to the technological giants in the USA from 2005-2019
How do management improve RoE?
As mentioned earlier, it is a common phenomenon that RoE declines for companies in the maturity phase. This is because, these companies have accumulated huge reserves over their tenure of operations. The denominator of the ratio becomes large, but the numerator does not increase proportionately. This leads to a natural decline in the ratio. The management has following options in such cases:
a. Buybacks of outstanding shares
b. Distributing profits in the form of higher dividends
c. Acquiring new businesses or raising capital expenditure
The suitability of each method for boosting RoE is important, but is outside the scope of this article.
How to interpret RoE and use it for making investment decisions?
It is a popular saying in stock markets that tough times do not last, but high RoE companies do. Let us see how we can use this learning in taking investment decision.
The actual interpretation of RoE is 'How effective is the management in generating returns over the money it has'. I as an investor, will be comfortable with a company with is doing a decent job with generating returns on the funds the company has.
Does this necessarily mean that high RoE companies are always outperformers? Well, the answer to this is high RoE companies may not be necessarily be high growth companies. There are companies listed on the Indian bourses which are high RoE, but low growth. One such example is Castrol India. Investors look forward to revenue growth as one of the important parameters before investing their capital. For high RoE companies, it is also important to know what Business activities they can expand from the accumulated reserves.
The Tequity way
We at Tequity, give first preference to high RoE, high profitability companies. However, our approach is pragmatic. We put our monies in these companies only when we see momentum picking up. We do not commit our capital to stocks which are operating in technical ranges (Supports and resistances). We wait for the major resistances to be broken, before investing. Over a period of all these years, we have developed the expertise for interpreting Technical Analysis tools. Get in touch with us for learning our techno-fundamental approach to investing and trading.