1 Return on Equity

Return on Equity
One of the most important profitability ratios is return on equity (or ROE for short).
Return on equity reveals how much profit a company earned in comparison to the
total amount of shareholder equity found on the balance sheet. Shareholder equity
is equal to total assets minus total liabilities. It's what the shareholders "own".
Shareholder equity is a creation of accounting that represents the assets created by
the retained earnings of the business and the paid-up capital of the owners.

By measuring how much earnings a company can generate from assets, ROE offers
a gauge of profit generating efficiency. The relationship between the company’s
profit and the investor’s return makes ROE a particularly valuable ratio to examine.

Why Return on Equity Is Important

A business that has a high return on equity is more likely to be one that is capable
of generating cash internally. For the most part, the higher a company's return on
equity compared to its industry, the better. This should be obvious to even the less-
than-astute investor If you owned a business that had a net worth (shareholder's
equity) of Rs.100 million dollars and it made Rs.5 million in profit, it would be
earning 5% on your equity (Rs.5 ÷ Rs.100 = .05, or 5%). The higher you can get the
"return" on your equity, in this case 5%, the better.

Formula for Return on Equity

ROE is equal to a fiscal year's net income (after preferred stock dividends but before
common stock dividends) divided by total equity (excluding preferred shares),
expressed as a percentage. As with many financial ratios, ROE is best used to
compare companies in the same industry.

Return on equity is particularly important because it can help you cut through the
garbage spieled out by most CEO's in their annual reports about, "achieving record
earnings". Warren Buffett pointed out years ago that achieving higher earnings
each year is an easy task. Why? Each year, a successful company generates profits.
If management did nothing more than retain those earnings and stick them in a
simple savings account yielding 4% annually, they would be able to report "record
earnings" because of the interest they earned. Were the shareholders better off?
Not at all. This makes obvious that investors cannot look at rising per-share
earnings each year as a sign of success. The return on equity figure takes into
account the retained earnings from previous years, and tells investors how
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effectively their capital is being reinvested. Thus, it serves as a far better gauge of
management's fiscal adeptness than the annual earnings per share.

The Du Pont Model

Companies that boast a high return on equity with little or no debt are able to grow
without large capital expenditures, allowing the owners of the business to
withdrawal cash and reinvest it elsewhere. Many investors fail to realize, however,
that two companies can have the same return on equity, yet one can be a much
better business.

For that reason, a finance executive at E.I. du Pont de Nemours and Co., of
Wilmington, Delaware, created the DuPont system of financial analysis in 1919.
That system is used around the world today and will serve as the basis of our
examination of components that make up return on equity.

The Three-Step Calculation

The three-step equation breaks up ROE into three very important components:

ROE = (Net profit margin)*(Asset Turnover)*(Equity multiplier)

These components include:

• Operating efficiency - as measured by profit margin.

• Asset use efficiency - as measured by total asset turnover.

• Financial leverage - as measured by the equity multiplier.

The Five-Step Calculation

The five-step, or extended, DuPont equation breaks down net profit margin further.
From the three-step equation we saw that, in general, rises in the net profit margin,
asset turnover, and leverage will increase ROE. The five-step equation shows that
increases in leverage don't always indicate an increase in ROE.
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This decomposition presents various ratios used in fundamental analysis.

• The company's tax burden is (Net profit ÷ Pretax profit). This is the
proportion of the company's profits retained after paying income taxes.

• The company's interest burden is (Pretax profit ÷ EBIT). This will be 1.00 for a
firm with no debt or financial leverage.

• The company's operating profit margin or return on sales (ROS) is (EBIT ÷

Sales). This is the operating profit per dollar of sales.

• The company's asset turnover (ATO) is (Sales ÷ Assets).

• The company's leverage ratio is (Assets ÷ Equity), which is equal to the

firm's debt to equity ratio + 1. This is a measure of financial leverage.

• The company's return on assets (ROA) is (Return on sales x Asset turnover).

• The company's compound leverage factor is (Interest burden x Leverage).

Sustainable growth rate

Sustainable growth rate (SGR) is the maximum rate at which a company can
grow revenue without having to invest new equity capital. If a company earns a
15% return on equity (ROE), it can grow 15% simply by reinvesting all the earnings
in new opportunities and maintaining a stable debt to equity ratio. In order to grow
faster, the company would have to invest more equity capital or increase its
financial leverage.

Basic formula

SGR = ROE * (1 – Dividend payout ratio)

SGR assumptions
• the company grows sales as rapidly as market conditions permit;

• the company maintains its existing asset turnover and profitability;

• management is unwilling to issue new equity;

• the company maintains it current capital structure and dividend policy;

• ROE can be split via DuPont Model for further analysis.

4 Return on Equity

ROA and ROE Give Clear Picture of Corporate

Health
Consider return on equity (ROE) and return on assets (ROA). Because they both
measure a kind of return, at first glance, these two ratios seem pretty similar.
Both gauge a company's ability to generate earnings from its investments. But
they don't exactly represent the same thing. A closer look at these two ratios
reveals some key differences. Together, however, they provide a clearer
representation of a company's performance. Here we look at each ratio and what
separates them.

ROE
Return on equity is a basic test of how effectively a company's management uses
investors' money - ROE shows whether management is growing the company's
value at an acceptable rate.

ROA
Return on assets reveals how much profit a company earns for every dollar of its
assets. Assets include things like cash in the bank, accounts receivable, property,
equipment, inventory and furniture. ROA is calculated like this:

The Difference Is All About Liabilities

The big factor that separates ROE and ROA is financial leverage, or debt. The
balance sheet's fundamental equation shows how this is true: assets = liabilities +
shareholders' equity. This equation tells us that if a company carries no debt, its
shareholders' equity and its total assets will be the same. It follows then that their
ROE and ROA would also be the same.

But if that company takes on financial leverage, ROE would rise above ROA. The
balance sheet equation - if expressed differently - can help us see the reason for
this: shareholders' equity = assets - liabilities. By taking on debt, a company
increases its assets thanks to the cash that comes in. But since equity equals assets
minus total debt, a company decreases its equity by increasing debt. In other
words, when debt increases, equity shrinks, and since equity is the ROE's
denominator, ROE, in turn, gets a boost. At the same time, when a company takes
5 Return on Equity

on debt, the total assets - the denominator of ROA - increase. So, debt amplifies
ROE in relation to ROA.

Because ROE weighs net income only against owners' equity, it doesn't say much
about how well a company uses its financing from borrowing and bonds. Such a
company may deliver an impressive ROE without actually being more effective at
using the shareholders' equity to grow the company. ROA - because its denominator
includes both debt and equity - can help you see how well a company puts both
these forms of financing to use.

So, be sure to look at ROA as well as ROE. They are different, but together they
provide a clear picture of management's effectiveness. If ROA is sound and debt
levels are reasonable, a strong ROE is a solid signal that managers are doing a good
job of generating returns from shareholders' investments. ROE is certainly a “hint”
that management is giving shareholders more for their money. On the other hand, if
ROA is low or the company is carrying a lot of debt, a high ROE can give investors a
false impression about the company's fortunes.

How Return on Equity Can Help You Find Profitable

Stocks
It pays to invest in companies that generate profits more efficiently than their rivals.
Return on equity (ROE) can help investors distinguish between companies that are
profit creators and those that are profit burners. On the other hand, ROE might not
necessarily tell the whole story about a company, and therefore must be used
carefully.

How Should ROE Be Interpreted?

ROE offers a useful signal of financial success since it might indicate whether the
company is growing profits without pouring new equity capital into the business. A
steadily increasing ROE is a hint that management is giving shareholders more for
their money, which is represented by shareholders' equity. Simply put, ROE
indicates know how well management is employing the investors' capital invested in
the company.

It turns out, however, that a company cannot grow earnings faster than its current
ROE without raising additional cash. That is, a firm that now has a 15% ROE cannot
increase its earnings faster than 15% annually without borrowing funds or selling
more shares. But raising funds comes at a cost: servicing additional debt cuts into
net income and selling more shares shrinks earnings per share by increasing the
total number of shares outstanding.
6 Return on Equity

So ROE is, in effect, a speed limit on a firm's growth rate, which is why money
managers rely on it to gauge growth potential. In fact, many specify 15% as their
minimum acceptable ROE when evaluating investment candidates.

ROE Isn't Perfect

ROE is not an absolute indicator of investment value. After all, the ratio gets a big
boost whenever the value of the shareholder equity, the denominator, goes down.

If, for instance, a company takes a large write-off, the reduction in income (ROE's
numerator) occurs only in the year that the expense is charged; the write-off
therefore makes a more significant dent in shareholder equity (the denominator) in
the following years, causing an overall rise in the ROE without any improvement in
the company's operations. Having a similar effect as write-offs, share buy-backs
also normally depress shareholders' equity proportionately far more than they
depress earnings. As a result, buy-backs also give an artificial boost to ROE.

Moreover, a high ROE doesn't tell you if a company has excessive debt and is
raising more of its funds through borrowing rather than issuing shares. Remember,
shareholder's equity is assets less liabilities, which represent what the firm owes,
including its long- and short-term debt. So, the more debt a company has, the less
equity it has; and the less equity a company has, the higher its ROE ratio will be.

Suppose that two firms have the same amount of assets (Rs.1, 000) and the same
net income (Rs.120) but different levels of debt: Firm A has Rs.500 in debt and
therefore Rs.500 in shareholder's equity (Rs.1, 000 - Rs.500), and Firm B has Rs.200
in debt and Rs.800 in shareholder's equity (Rs.1, 000 - Rs.200). Firm A shows an
ROE of 24% (Rs.120/Rs.500) while Firm B, with less debt, shows an ROE of 15%
(Rs.120/Rs.800). As ROE equals net income divided by the equity figure, Firm A, the
higher-debt firm, shows the highest return on equity.

This company looks as though it has higher profitability when really it just has more
demanding obligations to its creditors. Its higher ROE may therefore be simply a
mask of future problems.

Another pitfall of ROE concerns the way in which intangible assets are excluded
from shareholder's equity. Generally conservative, the accounting profession
normally omits a company's possession of things like trademarks, brand names, and
patents from asset and equity-based calculations. As a result, shareholder equity
often gets understated in relation to its value, and, in turn, ROE calculations can be
misleading.

A company with no assets other than a trademark is an extreme example of a

situation in which accounting's exclusion of intangibles would distort ROE. After
adjusting for intangibles, the company would be left with no assets and probably no
7 Return on Equity

shareholder equity base. ROE measured this way would be astronomical but would
offer little guidance for investors looking to gauge earnings efficiency.

Conclusion
No single ratio can provide a perfect tool for examining fundamentals. But
contrasting the five-year average ROEs within a specific industrial sector does
highlight companies with competitive advantage and with a knack for delivering
shareholder value.

Think of ROE as a handy tool for identifying industry leaders. A high ROE can signal
unrecognized value potential, so long as you know where the ratio's numbers are
coming from.

The ROE tells common shareholders how effectively their money is being employed.
Peer Company, industry and overall market comparisons are appropriate; however,
it should be recognized that there are variations in ROEs among some types of
businesses. In general, financial analysts consider return on equity ratios in the 15-
20% range as representing attractive levels of investment quality.