One of the many measures of performance of a company is RoE which measures the income generated by the shareholders’ equity. There are many other performance measures such as RoCE (Return on Capital Employed) and FCFE (Free Cash Flow to Equity holders) which can be used depending on the type of the company. In this article, we will restrict ourselves to RoE.
RETURN ON EQUITY (RoE)
For a matured company, the sign of health of a company is net income which is the part of the revenue after deducting the operating costs including depreciation of fixed asset, interest payments and taxes.
Note: for a capital intensive business, companies Cash Flow from the operating activities is a more appropriate because of the high non-cash expenses (depreciation and amortisation) which drags the net margin down. Automobile companies generally have very thin margins, but that does not mean that those companies do not perform well.
The Return on Equity is calculated using the below formula.
ROE = Net Income / Average Shareholders’ Equity
Net Income in this formula is before dividends are paid to equity shareholder but before any dividend is paid to preference shareholders. Shareholder’s Equity does not cover preference shares. So, RoE fundamentally measures the performance of the company for the equity shareholders.
The DuPont Analysis framework breaks down the RoE into different components to understand the drivers behind the RoE.
Let us rewrite the RoE formula
ROE = (Net Income / Revenue) X (Revenue / Average Total Assets) X (Average Total Assets / Average Shareholder’s Equity)
= Net Margin X Asset Turnover X Equity Multiplier
Now, let us understand each factor.
Net Margin measures the profitability of the operations. This is the part of the profit available to be distributed to the equity holders or invested back into the company. Although, the actual cashflow from the operations can be drastically different depending on how fast the company is growing (influencing the changes in the working capital) and non-cash expenses.
Asset Turnover Ratio:
Asset Turnover Ratio is calculated by dividing revenue with the average total assets of the business. This measures the ability of the business to generate revenue from the assets. It is possible that while the company operations are profitable, the company fails to utilise the assets on the books of the company. This ratio helps us understand that. A company with a lower Asset Turnover Ratio compared with its peers may choose to strengthen its Sales and Marketing team or liquidate under utlised assets.
A higher Asset Turnover Ratio is not necessarily a good thing. The company may refrain from capital investments which has driven the Asset Turnover Ratio higher. This means that the company may need cash for Capex in the near future or may have underperforming operations.
It is a measure of financial leverage. It is the ratio of Anverage Total Assets and Average Shareholders Equity.
This helps us understand how the assets of the company are financed – with equity or debt. The higher the Equity Multiplier, the higher the RoE keeping all else fixed. This means that simply taking on more debt by the company may improve the RoE numbers.
Note: While leveraging the company to increase the RoE may work in the short-term, in the long run it weakens the health of the company. Investors should be careful with companies which are manipulating RoE with debt. It increases the chances of default of the company.
This is a quick overview of the concepts. The RoE can also be expressed as
RoE = Return on Assets X Leverage
Another form is
RoE = (Tax Burden x Interest Burden x EBIT Margin % ) X Asset Turnover Ratio X Equity Multiplier