We all understand the Return on Equity (ROE) as the return generated on the equity of the company. Equity, here, refers to the share capital of the company plus its retained earnings. Reducing it to balance sheet terms, the Equity of a company can also be looked at as the net assets of the company (Total Assets of the company- all external liabilities). But why is ROE so important? There are 3 reasons for the same. Firstly, ROE captures the return that the company earns on the total equity. Cost of equity is higher than the cost of debt and that is why companies with higher ROE tend to outperform on the stock market. Secondly, equity is the residual stakeholder in the company after all outside liabilities are paid off. ROE captures whether the business is viable enough to effectively service that capital. Lastly, ROE captures the payback period or the frequency with which your capital is being churned by the company.
The need to break up the ROE..
The ROE as a ratio can also be misleading at times. For example, the company can artificially boost the ROE by relying more on debt rather than equity. That could have a negative impact on financial solvency although the ROE may be high. Secondly, the quality of the ROE depends on the quality of earnings. Earnings can be propped up by extraordinary items, accounting adjustments and through other investment incomes. However, these are not indicative of growth in the core business. That is why it is critical to break up the ROE into key components. By breaking up the components, you get a clear idea of each aspect of the ROE and help you to make a better decision.
How are the components of ROE broken up?
As we know the ROE is the ratio of the profits to the equity of the company. This can be mathematically expressed as under:
Return on Equity (ROE) = Profit After Tax / Total Equity of the Company.
To get a clearer picture of the factors underlying the ROE, we can further break up the ROE into 3 sub-equations as under:
ROE = (PAT / EBIT) X (EBIT / Sales) X (Sales / Assets) X (Assets / Equity)
In the above equation, the PAT/EBIT represents the financial leverage of the company. The EBIT/Sales component measures the operating margins of the company. The Sales / Assets ratio measures the asset turnover or the efficiency of asset utilization. Lastly, the Assets/Equity ratio measures the overall leverage of the company. The ROE can be positively impacted by improving any of the above four ratios. Let us now understand their specific significance.
The significance of the PAT / EBIT..
This measures the financial leverage or how the interest cost of the firm is managed. Normally, lower the interest burden and tax burden the higher is this ratio. You need to look beyond this ratio. This ratio can be propped up by smart tax management by deferring tax outflows. You need to factor that into your calculations. Secondly, in case of foreign currency borrowings, the interest cost only captures one part of the cost. The forex exposure is not captured and therefore this figure can be propped up by keeping forex loan exposure un-hedged. Also check if terms of the loan agreement have been temporarily adjusted to boost short term profits.
The significance of EBIT / Sales..
This is the ratio which, in many ways, is called the Bible for analysts. It actually measures the operating margins of the company earned from its core operations. For example if the company is in the business of steel, then this ratio only captures the profit generated from the core steel business. Operating profits exclude the impact of interest and tax but include the impact of the tax shield on depreciation as it is a productive business expense intended to refurbish assets in future. Similarly, all investment incomes and extraordinary incomes are excluded. This is a fairly reliable indicator of operating profitability of the company.
The significance of Sales / Assets..
This ratio captures how effectively your assets are utilized and churned to generate sales. A higher sales/assets ratio is a good sign as it shows that your assets are not lying idle and are being put to productive use. However, you need to be cautious of this ratio in case of asset-light businesses, where this ratio can be artificially high as the impact of intangibles are not considered. Similarly, focus on the consistent sales graph rather than get carried by spurts in sales.
The significance of the Assets / Equity ratio..
This is the ratio which you need to examine with a microscopic lens. It is very easy to manipulate this ratio by adding more debt than equity. It will take time for the interest cost to show up in the financial leverage and during that period this ratio may look artificially attractive. It may also boost the ROE in a manner that is not sustainable. Many companies have the tendency to boost their ROE through low-cost debt or foreign debt and this has to be factored into your calculations.
The trend matters more than the ROE, per se..
What is important to understand in ROE analysis is that in each of these four components above, the trend matters more than the absolute figure. Try to look at a 5 year trend or, better still, at a 16 quarters trend. This will throw up some interesting insights into where the company is heading and what it implies for the future valuations of the company. The moral of the story is that ROE, per se, can only tell you so much. It is only when you do a granular break-up that the ROE analysis really gives you interesting insights about the company!