Kiran (@_kirand) wanted me to do a post on my fascination with the ROE ! I hope this post benefits other retail investors too.
Return on Equity (ROE) basically is Profit after tax/Shareholders Funds * 100 OR EPS/Book Value * 100. Numerator is a part of P&L statement and denominator part of Balance Sheet.
In DuPont analysis which breaks the component of ROE,
ROE = Net Profit Margin*Asset Turnover*Equity Multiplier
i.e ROE = (Net Profit/Sales) * (Sales/Assets) * (Assets/Equity)
In other words, it is a function of profitability,operating efficiency and financial leverage.
A Company cannot grow its earnings over the long term greater than its ROE. Either it has to raise debt or dilute equity. One reason why banks keep raising money through equity every 3-4 years. Even the retailers and most of the infrastructure players.
ROE can be boosted by debt taken at lower interest rates. Textile Companies get loan at subsidised rate of interest of around 7% or companies with forex loans. So the narrower the gap between ROE and ROCE, the better it is for shareholders. Even better would be ROCE > ROE which will be possible if a company doesn’t have any debt and/or negative working capital.
Small Equity base also helps to enhance ROE (Hawkins Cookers is a case in point, 0.5cr shares and payout of 60% so addition to denominator is minimal). All other things remaining constant, a Company doing buyback will result in ROE expansion.
ROE should always be looked in conjunction with dividend payout ratio. Higher the payout ratio, higher the ROE, higher the probability of PE re-rating and hence higher the stock price! Money would be made from earnings growth but wealth created from PE re-rating. Many stocks continue to be cheap inspite of high ROE simply because of low payout. Markets tend to doubt the genuineness of numbers if the payout is low.
PE re-rating (P/BV in case of banks) doesn’t necessarily come from ROE expansion. Scarcity value can also help in PE Re-rating. Look at HDFC Bank or for that matter consumer facing companies stock performance over the last few years. As they say Good things are rare and they don’t come cheap in life.
PE ratio can expand to a certain level after which stock price track earnings growth. So to assume HDFC Bank can deliver more than 18-20% returns from here would be unrealistic.
Companies having strong ROEs tend to fall less compared to others in a bear market. One would have seen ITC,Nestle and Infosys falling 18-20% while the index fell 50% in 2008.
I always admire management focused on ROE/ROCE. Blue Star, Crompton Greaves, Kotak, Titan to name a few (Read the Chairman’s letter of these co’s in their Annual Report to know why).
P.S. Special thanks to Mr. Basant Maheshwari from whom I learned the importance of ROE.