To start and run any company require capital.

Capital for such business may be obtained using

various methods like the partnership, Public partnership via issuing shares, bonds, loans etc. so
before considering to be a partner in such business by purchasing equity share you must consider
the Return on Equity that company generates from each rupee of capital you invested in that
business.
Mathematical interpretation of the companys financial record involves ratio analysis of various
financial aspects. Mathematical interpretation is required to understand past performance and
future prospects of any business.
These ratios are very useful for understanding companys performance over the period of time
and peer group analysis within the same sector. Please remember Equity analyst uses a matrix of
ratio to evaluate the financial performance of any business. So please remember, no single ratio
can provide complete details.
Warren Buffet uses a series of fundamental indicators to identify solid companies worth
investing in. Some of the key fundamental indicators used by stock analyst are Return on Equity,
P/E ratio, Return on Capital Employed, Free cash flow etc.
Before investing your hard-earned money in any stock, you must check the various financial
ratio of the company to understand financial strength of the company. By analyzing various
financial ratios, you can compare the results with other company in same industry before making
the final decision to invest.
In this article, we will try to learn one of the important financial ratios to separate the wheat from
the chaff. In this series of articles on Fundamental equity analysis, we will try to learn various
key performance indicators. I like to warn you before you read further part of article;
Remember, sometimes you may feel company or sector may have a very impressive financial
ratio, but it might be seen very less impressive ratio in different industry or sectors.

What is Return on Equity (ROE)?

Return on Equity (ROE) = Net Income/Average Shareholders Equity
Net income means Net profit after tax and Average shareholders equity (Share Capital +
Reserve and Surplus) is derived from the average of shareholders equity at the beginning and at
the end of the year.
Return on Equity (ROE) is a tool to measure how efficiently the company manages investors
money in the business to generate a profit. It is a ratio of net profit earned by the company to
shareholders fund. ROE is called as Mother of all Ratios that can be measured from a
companys financial report.

Return on equity (ROE) provides straightforward analysis of how effectively management of the
company (Promoter) is in converting shareholders fund into profit; it measures the profit
returned for each rupee of shareholders investment. In other words, the return on equity ratio
shows how much the profit each rupee of common stockholders equity generates.
ROE is a critical weapon in the investors arsenal, as long as its properly understood for what it
is and how to utilize it.
By computing Return on Equity you can measure, how profitable company is and how it deploys
your money to generate profit for you. Companies with high return on equity enjoy higher
valuations.
The Higher ROE means the company is able to generate more money for the same amount
invested in the business. In Equity analysis, higher ROE is favourable means that promoter is
efficient to employ investors money to generate income on the new investment.
A company with a high Return on Equity does a very decent job of translating the capital
invested in it into the profit, and a company with a low Return on Equity does a bad job.
ROE increases if the company is able to reinvest its profit back to its business to generate a
higher return on investment. If the company does not choose to invest its retained profit and
keeps it in reserve and earned a similar profit in next year than its ROE would decline.
If companys dividend payout ratio is high, one should understand that future earnings growth
rate going to be a very less. If the company has faith in own future business and if it can earn the
high return on equity than it might prefer to lower dividend payout ratio and deploy the
remaining cash into a new project or to expand the business. If on the other hand, if the company
feels they do not have any new projects for business expansion than the company may go with
higher dividend payout. This enables shareholders to invest this money in some high ROE
stocks, rather than increasing idle cash surpluses on the balance sheet.
Lets take an example to understand in a simple way, if the company generated a profit of Rs.
1000 with shareholders equity of 5000 than Return on Equity (ROE) for this company is
1000/5000 = 20%. Suppose company dont distribute profit as dividend and if company generate
same profit next year than ROE will be 1000/ (5000+1000) = 16.6%. To maintain same ROE
which was 20% in previous year company needs to generate a profit of Rs. 1200. A declining
ROE is warning indicator, but one must identify the correct reason behind falling ROE,
sometimes it is due to new investment which is not generating profit same like existing
investment.
However, you should keep in mind that like other financial ratios, there is no standard way by
which we can define a business with good ROE or a bad ROE. Remember higher ratios are better
for selection, but what counts as good varies by company, industry, and economic
environment. Higher ROE can be the result of high financial leverage used by the company, but
too high leverage is sometimes dangerous for companys future and creditworthiness.

A Company that generates high returns will pay their shareholders handsomely and create
sizeable assets for every Rupee invested. These kinds of businesses are typically self-funding and
they do not require any kind of debt or equity investment to grow.
Remember, depending upon sector or industries, ratio will look different and hence one must
apply different benchmarking standards based on the future outlook of the company and of the
sector

HOW TO CALCULATE RETURN ON EQUITY?

Lets take an example of some real-life stock to understand how to calculate ROE of any Stock.
Please remember stock discuss here are purely for education purpose, Do not consider stock
discussed here as a recommendation from Financial Engineer.
Please remember for this article data used are from various websites and it may have slight error.
So, we suggest always use data from the annual report. I personally do not rely on data provided
by these websites.
An annual report published by the company is a good resource for collecting information about
companys financial position. You can find companys financial ratio on various websites, some
of the website provide readymade results for various financial ratio, however, I suggest please
double check these readymade ratios before selecting a stock.
If you are thinking to invest in a company, you want ROE to be high. If a companys return on
equity is low compared to its competitors, it is not utilizing available resources efficiently and
could go / be in financial trouble. ROE is valuable information and it only takes a few minutes to
calculate, using financial data from companys financial reports.
I am taking an example of one of the old and famous FMCG Company COLGATE, as you know
the company is in oral care products business. Looking at Colgates annual report, here is the tenyear financial performance highlight.

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Looking above financial performance report, Profit is improved from Rs. 137 Cr. in the year
2005-06 to Rs. 559 Cr. and shareholders fund increase to Rs. 770 Cr from Rs. 271 cr. reported in
the year 2005-06. In this ten year period, Profit rose almost 4 times and shareholders fund rose
around 3 times.
Now, lets take net profit after tax and shareholders funds from above report to calculate Return
on Equity. As per formula explained above Return on Equity is calculated by taking years
earnings after tax and dividing them by average shareholders fund for that year, remember ROE
is expressed as a percentage.

(Click on image to open image in new tab)

Higher ROE for one year may be due to various reasons as a long-term investor we should not
form an opinion to buy shares of the company by calculating ratios for just one year. Long term
investor always checks past records. I suggest you should look for more than 10-year trend
before the final conclusion. It should not be bad for more than one or two instances.
This gives a better idea of the companys average performance over a period of time. This would
give a reasonable assurance of the rate of return that the company is capable of generating. This
will help you to understand whether the business is worthy of investment or not. So based on
above information I have calculated ROE just by using a simple formula in excel sheet.
For the Year 2014-15, Colgates Return on Equity is 81.6%. This means Colgate created an asset
of 81.6 Rs from every 100 Rs originally invested. Look at the ROE of Colgate, Last ten year
average ROE is 103%, last five year and the three-year average is 102% and 96% respectively.
Please check the highlighted figures in the picture, Colgate slashed the face value of its share by
90% from Rs 10 to Re 1 in the year 2007. Colgate returned Rs 122.40 crores from its equity
capital of Rs 136 crores to shareholders, reducing the base to just Rs 13.6 Crores. by this move,
the number of shares issued and pattern of shareholding has remained unchanged.
See the effect of Reduction in shareholders capital on ROE, Return On Equity bumped up from
58% to 104% just because of reduction in Equity capital. This move also indicates the intention
of Colgate, surplus money which is not deployed in business who is generating 58% return on
Equity and if it is deployed in low yield investment like fixed deposit, will typically lower ROE
of the company.

So, by this example you must know that shareholders equity is denominator in ROE calculation,
means if a value of shareholders fund or Equity goes down, ROE goes up. Thus, share buyback
can falsely boost ROE. This is the reason you should check the trend of ROE over 5 or 10 year
periods. It can be artificially influenced by the promoters to boost the share price in the market,
using debt to reduce share capital. This will help them to show improvement in ROE of the
company even if profit remains constant.

Is this ROE Impressive? Lets Look at Competition.

As I said earlier, depending upon the industry or sector, the ratio will look different so to check
whether it is really high I compared it with its peer companies.
Colgates share is part of CNX FMCG Companies indices in National Stock Exchange (NSE),
CNX FMCG indices represent FMCG sector in NSE, and Top 10 constituents by weightage are,

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Lets have a look at its competitors ROE performance for the period of last ten, five and three
years. I am removing United Spirit and ITC from ROE calculation because of their nature of
business cant be compared to Colgate, former having majority of income from liquor business
and later having income from cigarette business. As I said to get the true picture one should
compare apple with apple, not with orange.

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k on image to open image in new tab)
Now looking at above results, no further explanation is required for identifying high ROE stock.
Please remember ROE is not the only indicator for stock selection. Have you noticed the ROE
improvement in Hind Unilever, Britannia and Emami?
You must have a question in your mind, what are the drawbacks of using ROE for stock
selection? ROE doesnt tell us whether company having access amount of debt or not. Keep in
mind, shareholders equity (which is denominator in ROE formula) is assets minus liabilities,
which comprise short term and long term debt. So, if the debt is more than equity, it will result in
higher ROE. This drawback highlights the need of analysing the trends of other underlying
instruments which may have a positive or negative effect on ROE.

The DuPont formula to Calculate Return on Equity

The DuPont formula has a the solution for the concern raised above by breaking down the return
on equity and allowing you to see which factors are helping or hurting ROE of the company.
DuPont Formula will help you to decide whether promoters are generating value for shareholders
effectively or not. I suggest you must use DuPont formula once you finalized your stock list
using first ROE formula to save some time.
Please keep in mind that high ROE might not show the true picture about companys operation.
The reason is simply taking huge debt company may exhibit a strong ROE. Any business which
is funding growth through borrowings eventually leads to higher interest burden which may
affect profitability in the long run.
Due to these limitations, it is required to identify, what is fuelling the returns. DuPont model
helps you to deconstruct the ROE matrix into distinct parts, which helps you to identify how

company achieving its ROE by increasing profit margin over the period or by using leverage or
due to higher asset turnover. By using DuPont analysis the ROE is calculated as follows;

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Three Step DuPont model capture the efficiency of companys Promoters to generate profit using
net profit margin (Net Profit Margin = Net profit or Net Income / Sales), utilisation of assets
(Asset turnover= Sales/Total Assets) and using leverage (Equity Multiplier = Total
Assets/Shareholders Equity).
As an Investor, I prefer to put my money in the company which is able to generate the High ROE
by improving its net profit margin or optimum utilisation of Assets or both.
The Net Profit Margin shows how much earnings the company generates from each rupee of
sales. A higher or increasing profit margin suggests its pricing power and competitive advantages
over its peers. High-profit margins suggest company enjoying Moat. Because of products brand
Image, Company enjoy the pricing power and can sell products at a higher margin compare to its
peer companies. Because company having moat advantage, the company can eliminate
competition from any newcomers by lowering pricing or improving customer satisfaction by
improving product or / and service quality.
Asset Turnover of the company measures how much sales it generates from each rupee of
assets. Generating more sales on fewer assets implies that the company is not required to invest
more funds to purchase assets in an effort to generate revenues. It essentially indicates the
managements efficiency in utilising its existing assets to drive sales.
Coming to the last part of DuPont formula, if the company is using excessive Leverage (Equity
Multiplier) to boost companys ROE than, it could be an alarming sign. If the company already
have high debt and if company continue to increase debt then it may increase the risk of credit
default or we can say the company may go bankrupt.
Return on Equity has three primary drivers, Better turnover (sales), higher margins and high
level of debt and each of these can lead to higher ROE. Return on Equity is good performance
indicator, but it does not tell you what are the other factors which are helping or hurting the
performance of your company.

Factors that affect Return on Equity.

Share Buyback
Generally company using buyback option to raise own shareholdings in the company if they are
confident in future earnings but another reason a company might look for share buyback is just to
improve companys financial ratio where investor like you and me are heavily focused on ratios.
But if companys motive for doing buyback is to create wealth for investors, then improvement
in various financial ratios is the by-product of managements decision.
Lets have a look on how buyback improves Return On Equity (ROE); first of all, the
buyback will reduce the number of outstanding shares. Moreover, the buyback will reduce the
shareholders reserve from the balance sheet. As a result Return on Equity will increase because
of less outstanding equity and reserve. In general equity analyst and market views higher ROE as
a positive signal.
Suppose a company having total equity of 100 shares and it offers the buyback of 40 shares out
of 100 outstanding shares at the rate of Rs. 100 per share. The company will utilize its cash
reserve to for buyback. Below is the calculation showing how the financial indicators will
change by this move.

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new tab)
See the effect of Buyback on ROE, without increasing profit ROE increase to 47% from 10%.
Please note, stock buyback does not change net profit but decreases shareholders capital and
reserve after the buyback. Share buyback also helps to improve the other financial ratios.
For Example buyback will decrease P/E ratio, when it comes to P/E ratio lower is better. Fewer
share + same earnings = higher earnings per share. The formula for P/E ratio is Current share
price/Earnings per share (EPS). So if I use P/E ratio as a measure of value than the company is
less expensive than it was prior to the buyback, in fact, is there is no change in earnings.
Likewise, if the company increases the number of shares instead of increasing debt for business
expansion, Return on Equity will be affected. Issuing new shares to the investor will increase the
shareholders capital. So, without any impact on net profit ROE will decline because of the
higher value of shareholders equity.

Irregular Profit Activities

Some companies invest in forward contracting to hedge currency risk. If any additional profit
generated from this investment will improve companys bottom line, which will result in
improvement in ROE. If investment turns into losses will reduce net profit and ROE.
The sale of Plant, Equipment or any assets in given period also boost revenue, improve the
bottom line and ROE. Same way irregular expenses like one-time legal fees or fine in given
period of time will lower the profit and subsequently it will reduce ROE.

POINTS TO REMEMBER

Financial Ratios are very useful to check and understand the companys
performance over the period of time.

With the help of Small mathematical calculation, you can understand financial strength of
the company and make the comparison with other companies in the same sector.

Always compare financial ratio within same sector company, remember ROE of 30
seems less impressive for FMCG sector, but it might be seen more impressive in Banking
sector.

Return on equity provides straightforward analysis of managements capability in profit

generation.

Higher ROE is better, but check what is fuelling ROE.

A declining ROE is warning indicator, you should identify the correct reason behind
falling ROE before making any decision.

Due to various reasons, ROE can be higher for one year. always check ROE trend for
minimum 5 years.

A company with high ROE over the period of 5 years must have reduced the debt during
the same period. So ideally the company who is generating high ROE may have almost
nil or low debt.

Simple ROE formula doesnt tell about the company having how much amount of debt,
use it to eliminate junk during stock screening.

Use DuPont analysis to check what is fuelling ROE, is it due to improved profit margin
or due to leverage or due to asset utilisation?

Share buyback will improve ROE and increasing share capital will reduce it.

Please share your views and query by comments. Let me know if you find some good stock with
high ROE.