Higher RoE Great But Not Always!

Ratio analysis is a crucial step in equity research. Return on Equity (RoE) is one of the most popular ‘financial (return) ratios’ that investors often track while analysing the quality aspects of any listed stock. Investors however, often make a mistake of considering ‘RoE’ objectively, which may lead to poor investment decision-making. Anthony Fernandes explain how best to interpret ‘RoE’ for investment decision-making not before he explains in detail how RoE is calculated!

Investors who have spent enough time in the market might confess that, each year teaches you a different aspect about the equity markets. At times, market rewards momentum investors more than the value investors while, in certain phases of the market, we have seen value stocks do better than high beta stocks and momentum stocks. At times, we see stocks of certain sector do well and then, there is a sectoral rotation and different sector stocks lead to different market rallies.

For sure, the equity market is dynamic, and it is unprofitable to look at the markets objectively- a mistake most novice investors make. On similar lines, a common mistake that most investors can easily make is looking at the RoE data objectively. There is a tendency to give more importance to RoE, than is required especially when the RoE is high for any stock under consideration. Having said that, it is observed that very few investors actually understand how to best interpret RoE as a measure of profitability of the company.

What is RoE after all and why is it considered so important that is almost religious to study company’s RoE before making any investment decision?

Return on Equity  

To understand the concept of RoE, we first need to appreciate the importance of financial ratios.

Financial ratios ideally are compared with those of its major competitors. The main purpose of financial ratio analysis is to understand the underlying causes of divergence between a company’s ratios and those of the industry. Such analysis is also known as the crosssectional analysis and trend analysis.

RoE tells you what percentage of profit you make for every rupee of equity invested in your company.

RoE is one of the most important profitability ratios, often used in tandem with the Return on Invested Capital (ROIC) and Return on Capital Employed (ROCE). It is perceived that the negative RoE companies are to be avoided and the low RoE companies should be studied with extreme caution, even as the preference should be given to those companies which have more than 20 RoEs.

RoE as a financial ratio calculates the amount of net profit earned as a percentage of shareholders equity. RoE is one measure which tells us about how well the company has utilised shareholders’ money.

Definitions of Commonly Used Profitability Ratios

Du Pont Analysis : The Decomposition of ROE 

As discussed earlier, RoE simply measures the return a company generates on its equity capital. For any long-term investors, who decides to park his money in quality stocks, it is always interesting to understand what drives the company’s RoE. One of the most widely-used techniques to decompose RoE and understand what drives the RoE is DuPont analysis. The technique is famous by such name because it was developed originally at that company. Decomposing RoE by adopting DuPont analysis would involve expressing the basic ratio of ‘net income /average shareholders’ equity’ as a product of component ratios. Each of these component ratios is an indicator of a distinct aspect of a company’s performance that affects RoE and hence, it is feasible to evaluate how these different aspects of performance influence the company’s profitability as measured by RoE. In other words, decomposing RoE is useful in ascertaining the reasons for changes in RoE over time for any given company as well as ascertaining the differences in RoE for different companies in a given time period. DuPont analysis help investors and analysts understand that the company’s overall profitability, measured by RoE, is a function of its efficiency, operating profitability, tax burden, interest burden and use of financial leverage.

DuPont Analysis Equation 

RoE = Net Income / Average Shareholders’ equity
= (Net Incomes/Average Total Assets) X (Average Total Assets/Average shareholders’ equity)
= RoA X Leverage

We can say that RoE is a function of a company’s Return on Assets (RoA) and the financial leverage that the company is operating with. Thus, for any company to reflect higher RoE, it has to come from better usage of its assets as is reflected in RoA (Net income/ Average Total Assets) or optimal use of its leverage.

The company has to ensure that the return it generates from investments is higher than the borrowing cost. As long as it is able to generate returns higher than the borrowing cost, the company keeps adding value and contributing positively to the RoE. The moment, the borrowing cost is higher than the return on investments, the RoE will be impacted negatively, and this is the precious reason why investors ought to track the leverage of any company that it intends to invest in.

It is quite possible that the company has stable leverage but it is not able to improve its utilisation of assets, i.e., there might be inefficiencies in the asset utilisation which may impact the RoE negatively. As an investor, an ideal company for investment is the one that uses the leverage effectively and utilises the assets efficiently.

For those with curious minds, RoA can further be decomposed just as RoE as below:- 

RoE = Net Income/Average shareholders’ equity
= Net income/Sales X Sales/Average total Assets X Average Total Assets/Average Shareholders’ Equity
= Net profit margins X Total asset turnover X Leverage

The above equation reflects how the RoA is decomposed into net profit margins and asset turnover ratios (efficiency indicator). Leverage helps us understand the solvency of the company. The above equation helps us understand that the RoE is a function of profit margins, asset utilisation and leverage. 

To separate the effects of taxes and interest, we can further decompose the net profit margin and write: 

RoE = Net income / Average Shareholders’ equity
= (Net income/EBT) x (EBT/ EBIT) X (EBIT/Sales) X (Sales/Average Total Assets) X (Average Total Assets/Average shareholders’ equity)
= Tax burden X Interest burden X EBIT margin X Total Asset Turnover X Leverage 

Thus, we can say that RoE for any company will depend upon the tax rate, interest rate burden, operating profitability, efficiency of assets and leverage. This helps investor analyse what factors of the company are driving the RoE, and which area is a concern from the investment point of view.

Empirical evidence: High RoE vs Low RoE 

If we take a look at the RoEs of BSE 500 companies and attempt to understand the stock returns in 2019, we find that the higher RoE stocks on an average have generated slightly better returns than those reflecting lower RoEs. The below table highlights the fact that those companies (127) with RoE greater than 20 on an average have delivered 4 per cent returns on YTD basis while, those companies between RoE of 20 and 10 have managed to deliver a negative 0.25 per cent return. The companies with even lower RoEs i.e between 10 and 0 have shown poor performance in 2019. The average returns for the companies (122) with RoEs between 10 and 0 have been 13 per cent negative. BSE 500 in the similar period has delivered 7 per cent returns while, BSE Sensex has generated close to 15 per cent returns.

Out of 500 stocks that are constituents of BSE 500, we find that there are 127 stocks with RoEs greater than 20. When compared to the set of companies with RoEs less than 20 but higher than 10, we find that the average P/E for the stocks with RoEs greater than 20 is lower. Average P/E is higher for those set of stocks with lower RoEs as reflected in the table.

When we attempt to identify the stock price performance for the stocks with higher RoEs versus lower RoEs for listed stocks with market capitalisation greater than `1,000 crore, we find that the average stock returns are higher for those stocks which have higher RoEs. Again, we observe that the average P/E is higher for those set of stocks that reflect lower RoEs and vice versa.

Don’t get misled by high RoEs 

The problem with RoE is that investors are led to believe that the high RoE companies are actually highly profitable, which may not always be the case. Few analysts believe Return on Invested Capital (ROIC) is actually a better measure of profitability, as it removes the impact of unusual one-time charges and hidden off-balance sheet items. The impact of financial leverage is minimised to calculate the true profitability of a firm, in case of ROIC. Few believe that ROIC has a better ratio as it uses Net Operating Profit After Tax (NOPAT) as the numerator

One can argue that any true measure of profitability should reflect in the operations of the business without being impacted by the financing decisions. However, we have seen that RoE is greatly influenced by the leverage factor. Any company with an average operational performance may boost RoE by simply leveraging more. This may lead to higher riskiness of the firm and as an investor, he or she may conclude higher RoE is better profitability thus, ignoring the higher riskiness of the firm.

NOPAT will exclude financing costs and instead, use consistent rules, across all companies and time frames as well as adjusts the impact of usual items and changing management assumptions.

Also, it is possible that an investor may find a quality company with superior operational capabilities with a lower leverage reflecting a lower RoE. If an investor objectively decides to invest using RoE data, the investor may miss on the quality company with operational capabilities only because such companies reflect lower RoE owing to lower leverage.

Another advantage that ROIC has over RoE as perceived by several analysts, is the fact that ROIC is highly correlated with enterprise value/invested capital. The correlation suggests that the companies that improve their ROIC and not RoE, are more likely to see their stock prices rise. The risk thus, for objectively looking at RoE, is that an investor may mistakenly believe an expensive stock to be of some value and that a value stocks may look extremely expensive and thus avoidable.

Conclusion 

It is easy to calculate RoE and hence, it is popular among investors. The simplicity of RoE can be misleading though. The biggest mistake that an investor can make is to look at the RoE data objectively and then make investing decisions.

Though RoE data is quite useful, it does not provide the whole picture. If an investor identifies that the RoE is lower for his company when compared to its peers, the investor can use DuPont Analysis system to identify the weakness. The DuPont analysis system will help investors significantly understand the drivers for the RoE. As is the case with other financial ratios, RoE can be used in conjunction with ROIC, ROCE and other financial ratios to get a holistic picture of the company.

Investors can have a slightly positive bias towards high RoE stocks (20 per cent +) when compared to low RoE stocks however, other fundamental aspects need to be observed minutely before making investing decisions.