Importance of ROE

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.

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9 responses to “Importance of ROE

  1. Nilesh Agrawal

    Hi Devesh,
    Great Post as always. I agree that RoE is an important parameter in investment decisions.
    Have a query regarding your Statement “Even better would be ROCE > ROE which will be possible if a company doesn’t have any debt and/or negative working capital”
    As I understand CE = Equity + LT Debt (or TA-CL). How can a company have RoCE>RoE without any Debt or -ve WC.
    Also, as far as my understanding is concerned RoCE would always be compared to Cost of LT Debt. If RoCE>Cost of Debt, the extra returns generated from employing debt flows to equity holders enhancing RoE. Help me out if there are gaps in my understanding.

    Also there is a catch. I believe that Buy back is an incorrect method to enhance RoE. Here a company uses part of shareholder’s funds (lets say from reserves) to buy back some shares at market price; reducing book value considerably by paying out cash. This reduces the Shareholder’s funds & with same profitability RoE looks higher. Actually the book value per shareholder has reduced and is bad for existing shareholders.

  2. Hi Nilesh, while we consider Net Profit (in the numerator) in ROE, EBIT is used to calculate ROCE. So Interest and Tax is excluded from numerator while the denominator only consist of Equity since there is no debt hence ROCE being greater than ROE.

    I agree that ROCE > cost of debt is good for shareholders. But then some portion of shareholders is taken by the bankers.

    Buyback make sense for co’s which is not sure how to utilize the cash efficiently. It indicates the company doesn’t see any avenues for expansion/growth which is bad for shareholders as market pays for growth. But if the stock is attractive enough to buyback by using small portion of cash and there is growth like in the case of SRF, then its good for shareholders.

  3. I thought we use EBIT(1-T)/CE for RoCE. The effect of Tax on return is more or less mitigated.
    What you said about buyback in case of no growth avenues makes total sense. Better in paying off as Dividend I say. But if the company is growing, wont it make more sense to redeploy that money and generate higher returns for the shareholders, rather than returning cash.

  4. Thanks Devesh for the wonderful explanation of the importance of ROE.

    I have created a screen with the parameters given in the post have have sorted the results on the least number of shares:

    bit.ly/Uo8efz

  5. Devesh great post on DuPont analysis. Excellent explanation on high ROE and low payout and low stock valuation. Would be great if you write about managements that focus on ROE rather than on overall growth. Thanks!!!

  6. Any owner of a business gets ROE on the capital invested in business. Thus logically high ROE of businesses must result in high profit to the shareholders!!! Shaughnessy’s study says otherwise (What works on wall street)- stocks with high ROE generally perform in line with market. Thus buying stocks solely based on ROE may not be a very good idea; for high ROE generally means- higher profit in recent times which may be cyclical in nature or high market price of the stocks. Further higher ROE is likely to attract competition leading to reversion to mean of ROE in future.
    Still, I am of the view that it is a great measure of efficiency and competitive advantage of a company and it can be a very useful tool if employed in conjunction with value measures- magic formula uses it in conjunction with low PE.

  7. Earnings growth,high payout and 25%+ ROE is how I invest in equities. So if anyone of them is a miss, then I don’t proceed further.

  8. if “Growth > ROE, cos will have to grow with increasing debt”. Now look at two examples prior to 2008/2009 crash. Company X(u know this cos very well in detail) was growing with very high ROCE (almost 50%). As growth was less than 50% they were giving either huge dividend payout(its peer with same fundamentals) or investing excess in equities. Due to this great financials which everyone on street was knowing, cos fetched almost 50 PE. But one bad year and working capital increased drastically and PE crashed to 5 thus 90% loss. Now consider another company Z which has exactely bad charactistic as above “Growth > ROCE”. Undoubtely Z’s debt was rising in same space. But one good thing about this cos was consistentely it had Operating cash flow greater than its PAT. In 2009 with margin doubleing from 5% to 10%, it retired its whole debt and reduced invetory which lead to drastic change in ROCE and hence PE rerating from 5 in and hence PE rerating from 5 in 2009 to PE 17 with EPS tripling in 4 years which lead to 10-bagger. X:Voltas/Bluestar and Z:Amara Raja. So whats point is analysing RCOE as “Great ROCE doesn’t mean great future”, “Bad ROCE (with rising debt) doesn’t mean bad future”, “Medicore invesments could be created from great ROCE cos”, “Great investments could be created from basd ROCE business”??

  9. Excellent point. As I said stocks will track earnings growth after a certain level of PE ratio. It’s just that my post considered the Rerating part and not the derating part.

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