Return on Equity (ROE) is a popular financial metric used in assessing investment decisions. It tells you how much income the business is generating relative to shareholders’ equity. Investors use ROE to evaluate capital allocation decisions of firms. Companies with high ROEs tend to get higher valuation as compared to companies with lower ROEs.
Companies can increase ROE either by increasing net income, by improving sales and profitability, or by decreasing shareholders equity by share buybacks.
However, for management, it is not just about generating high Return on Equity but achieving an optimal level of capital structure and returns to complement sustainability. They can hit high ROEs by loading an unusual amount of debt at high intensity compared to equity and increase their sales.
Debt can manipulate ROEs and capital intensive businesses ought to have long debt cycles, therefore it is perennial to look at business models and take appropriate measures. Market participants also compare ROEs of comparable companies to get better answers to divergences.
Investors consider ROEs as one of the measures to evaluate the performance of a bank. The spread between ROEs and banks cost of equity has served as an indicator of profitability for market participants. Besides, the benchmark ROEs for banks is dependent on business cycle, time period, and interest-rates.
The A2 Milk Company Limited ROE Calculation, Image Kalkine (Data Source: 2020 Annual Report)
Net Income or Net Profit After Tax is given in the income statement of the company, and shareholders’ equity is reported in the balance sheet. Shareholders’ equity is taken as an average of beginning and ended. Should there be a large equity issue or buyback of similar scale, the ending amount of shareholders’ equity will give a better picture.
What are the limitations of using ROE?
Debt: Return on Equity is calculated without incorporating the debt in the balance sheet, meaning that the increase in net income is perhaps driven by debt funding as well. Even the companies with massive debt and relatively lower equity capital can boast high ROEs. A massive debt could be a problem for businesses, and a high ROE may give a false picture. Companies with high debt to equity ratio could report optically high ROE figures.
Depreciation: Depreciation is an expense that is recorded in the income statement of the company. It is incurred on the assets held by the business like plant and machinery, factory, trucks. A business in a growth stage can have addition of large assets, which would result in lower-income over the future due to increased depreciation.
Write downs: Assets of the company are also valued to determine any changes to the fair value of assets. The companies charge impairments to assets when current valuation is lower than the previously reported amount, which lowers assets value booked on the balance sheet.
Buybacks: Companies can also show better ROEs after buying back a lot of shares of the company, which reduces the shareholders’ equity. A lower amount of shareholders’ capital denotes that Return on Equity must have been higher.
Profits: Business with inconsistent profit-making ability lower the shareholders’ equity as loss are recorded as a retained loss in the balance sheet. After a period of losses, the deterioration in shareholders’ equity can cause ROE to be extremely high when a company swings back into profits.
Comparing two businesses within same industry with different capital structure becomes a challenge. Thus, analysts also use other ratios such as ROCE – Return on Capital Employed.
What is DuPont Model?
DuPont, a chemical company, introduced a method to calculate ROE and broke the equation into three parts: asset efficiency, leverage and operating efficiency. The method has three separate calculation of Net Profit Margin, Total Asset Turnover and Equity Multiplier.
Net Profit Margin allows testing the operating efficiency by calculating the net profit relative to the net sales in percentage terms. Total assets turnover helps to determine the asset efficiency by dividing sales by total assets. Equity Multiplier is determined by dividing Total Assets by Common Equity, representing financial leverage.
Read: Return on Assets
ROE = Net Profit Margin x Total Assets Turnover x Equity Multiplier
Net Profit Margin = Net Profit/Sales
Total Asset Turnover = Sales/ Total Assets
Equity Multiplier = Total Assets/Common Equity
A high ROE driven by an improvement in Net Profit Margin and Asset Turnover signals a positive sign for the business, but a rise in equity multiplier may indicate that business is taking further risks. When a business has sustainable leverage similar to its industry, it shows efficient management of capital sources.
Even if the increase in Return on Equity is driven by leverage along with deterioration in other parameters, it would indicate that business has maintained its ROE largely due to an increase in leverage.
5-Step DuPont Model
A five-step DuPont Model is a further extension of the basic DuPont model. This model argues that an increase in leverage may not always mean an increase in ROE. It was created to further segregate the net profit margin, allowing to assess the impact of interest payments of debt on net profit margins.
ROE = (Tax Burden) x (Interest Burden) x (Operating Margin) x (Asset `Turnover) x (Equity Multiplier)
Tax Burden = Net Income/EBT
Interest Burden = Earnings Before Taxes/Earnings Before Interest & Taxes
Operating Income Margin = EBIT/Sales
Asset Turnover = Sales/Total Assets
Equity Multiplier = Total Assets/Shareholders’ Equity
What is an Absolute Advantage? Absolute advantage is one of the key macroeconomic terms, which is based on the principles of Capitalism and is often utilised in international trade-related decisions. Absolute advantage refers to the competence of a company, region or country to produce goods or services in an efficient manner compared to any other economic entity. The efficiency in production can be achieved by: Production of the same quantity of good or services as produced by other entity by utilising fewer amount of resources Production of a higher quantity of good or services as produced by other entity by using the same amount of resources What is the Significance of Absolute Advantage? Different countries or businesses possess a different set of ability owing to their location, soil composition, weather, infrastructure, or human resource skills. When applied in the right direction, various factors may pan out to offer more cost-effectiveness and hence build absolute advantage of the entity in comparison to others. The absolute advantage remains one of the critical determinants for the choice of the goods or services to be produced. Absolute advantage in a particular area often translates into profitability in the area. The profit margin increases by the achievement of cost efficiency, allowing the entity to ensure higher profitability over the competitors. For example, let us assume that the US can produce ten high-quality aircrafts utilising a specific amount of resources. China, on the other hand, can build 6 similar quality aircrafts using the same amount of resources. Thus, in the production of an aircraft, the US holds Absolute Advantage Let’s say the US has the ability to manufacture a certain amount of steel using 10 tonnes of iron ore. China, on the other hand, can produce the same quantity of steel using 8 tonnes of iron ore.Here, China here holds Absolute Advantage in the production of steel. How Countries Build Absolute Advantage? While natural conditions, which include climatic factors, geometry, topography, cannot be altered for achieving absolute advantage, the countries use the underlying factors strategically in their favour. Furthermore, factors of production are focused at by many companies or nations for building absolute advantages. Some of the strategies for building absolute advantage includes: Development of Technological Competencies- The implementation of innovative or latest technological innovations allows the entities to lower their production cost, facilitating absolute advantage. Enhancing Skills of Human Resources- The improvement in the cost-efficiency, along with the quality of the products, is targeted through imparting varying skill development programs. Many countries subsidize or aid the apprentice or labour training for enhancing the absolute advantage in trade. Improving Infrastructure- The infrastructure enhancement in the form of road, telecommunications, ports, etc. can be useful in enhancing the cost-effectiveness across different industries. What Do We Understand by Comparative Advantage Vs Absolute Advantage? Evaluating the comparative advantage introduces the concept of opportunity cost, which is the deciding factor to determine the production of particular goods or services. Opportunity cost refers to the potential benefits associated with the next best possible alternative which is missed out when one option is chosen over another. The Absolute advantage simply considers the capability of a business or region to deliver goods or services in the most efficient manner. The Comparative Advantage, however, also takes into account the benefits that are forgone if an entity decides for production of a particular product or services. Comparative advantage, based on the notion of mutual benefits, is often used in international trade deals. The Comparative advantage has been the major factor driving the outsourcing of services in search of cheap labour. Understanding through an Example For instance, country A can produce ten televisions with the same amount of resources with which it can make 7 laptops. The opportunity cost per television is 7/10 or 0.7 laptops. Meanwhile, the opportunity cost per laptop is 10/7 or 1.42 television. It highlights that country A is forsaking the production of 0.7 laptops if it is deciding to manufacture one television. On the other hand, it is missing out the opportunity to manufacture 1.42 televisions for every single laptop manufactured. Now, say Country B’s opportunity cost for producing a television is 0.5 laptop, and that of producing laptop is 2 televisions. Then, country B will have a comparative advantage in making televisions, and country A will have comparative advantage in producing laptops. It has to be noted that despite country A having absolute advantages in both the products, it would be mutually beneficial for both the countries if country B produces television while country A produces laptops. Do You Know About Absolute Advantage Theory by Adam Smith? The concept of Absolute Advantage was indicated by Adam Smith in his book called ‘Wealth of Nations’ which focusses on International trade theory. Adam Smith, in his book attacked on the previous mercantilism theory, which mainly stressed for economies to maintain trade surplus in order to command power. The Absolute Advantage theory considered that the countries possess different ability with respect to the production of varying goods or services. It argued that it is not necessary that a state may hold an absolute advantage in the production of all goods, and here the relevance of trade comes into play. It advocates that countries should produce those goods over which they hold a competitive advantage. It would allow the countries to make the same amount of goods using few resources or in less time. The theory propagates the relevance of trade for economic sustainability. What Are the Limitations of the Absolute Advantage Theory? The assumptions used in the Absolute Advantage Theory by Adam Smith may limit the application in real bilateral trade. The limitations of the theory by Adam Smith include: Smith assumed that the productive capabilities of a country could not be transferred between the two countries. However, in practical terms, the competitive scenario aids the nations to acquire new capabilities and acquire new resources, especially in the technological and human resource skill aspects. The two-country trade which was used as a basis for the theory does not consider the trade barriers levied. The present scenario, however, is strikingly dominated by trade wars between economies. Nations impose huge tariffs, import duties and other type of barriers to promote local manufacturers. Absolute Advantage theory assumes that the trade between the two nations will take place only if each of the two economies holds an absolute advantage in one of the commodities traded. However, in general, countries despite not holding absolute advantage are engrossed in international trade, boosting their economic setup.
Difference between actual and an expected return. For example, if a stock increased by 7% because of some update, but the average market only increased by 3% and the stock has a beta of 1, then the abnormal return was 4% (7% - 3% = 4%)
Ability-to-Pay Taxation The neoteric trending concept in which the tax is levied as per the taxpayer’s economic ability to pay. It is based on the concept that a person who earns more should pay more taxes and the one earning less should pay less.
Gain or loss as a percentage of the initial capital invested. For example – If we gain $10 on investing $100, our Absolute return would be 10% ($10/$100*100)