Financial ratios of a company are compared with its major competitors in the industry to understand the causes of divergence between the company's ratios with that of the industry. In this context, Return on Equity (RoE) is considered as one of the most relevant ratios in stock selection.
What is RoE?
It is a financial ratio that calculates the amount of net profit earned as a percentage of shareholder equity. It exhibits how efficiently a company has used shareholders' money. In fact, RoE is computed as net profit divided by net worth. When a company has a low RoE, it means that the company has not used the capital invested by shareholders in an efficient manner. Generally, companies with RoE of 20% and above are considered as good investments and investors should exercise extreme caution for companies with negative RoE.
Decomposition of RoE
Being a long-term investor in stock markets, one should examine what drives RoE of the company. DuPont Corporation, one of the world's largest chemical companies, breaks the ROE and decomposes it further into three components to analyse where the returns are coming from. Accordingly, the three components are net profit margin, asset turnover, and the equity multiplier.
Net profit margin
This is calculated by dividing the net profit by total revenues. The primary factor remains to maintain healthy profit margins and derive ways to keep growing it by reducing expenses, increasing prices, etc, which impacts RoE. For instance, Company A has annual net profits of Rs 1,000 and annual turnover of Rs 10,000. So, net profit margin is 10%.
This ratio computes the efficiency of the company in using its assets. This is calculated by dividing revenues by average assets. If the company's asset turnover increases, it positively impacts the RoE. For instance, Company A has revenues of Rs 1000 and average assets of Rs 200. Asset turnover is 5.
The equity multiplier is a tool to analyse what portion of the RoE is a result of debt. This refers to the debt usage to finance the assets. The debt should be used to finance the operations and growth of the company.
However, usage of excess debt to push up the RoE can turn out to be detrimental for the health of the company. For example, company A has average assets of Rs 1,000 and equity of Rs 400. Hence, the equity multiplier is 2.5.
Let us take company A and B. Both firms belong to biscuit manufacturing industry with the same RoE of 35%. Which one is better to invest? ). By decomposing, we found the following (See graphic):
Even though both companies have the same RoE, the operating performance of companies are totally different. Company A is able to generate higher sales while maintaining a lower cost of goods which can be seen from its high-profit margin. But company B is selling its products at a lower margin but have very high asset turnover ratio indicating that the company is utilising assets effectively to generate more sales. Further, company B is, less risky as its financial leverage is very low.
Thus, DuPont analysis helps compare similar companies with similar ratios.
It will help investors to measure the risk associated with the business model of each company.
The writer is a professor of finance & accounting, IIM Tiruchirappalli