Return on equity? Now what's that?

What is the 'Return on Equity' ratio? We discuss this ratio that deals with book-value or 'equity'. It and is used to measure the 'efficiency with which a company utilises the equity capital.'

How is RoE calculated?

RoE is calculated by dividing the 'profit after tax' earned in an accounting year with the 'average equity capital' as mentioned in the balance sheet of the company.

Let us take the example of Infosys. The company earned a profit after tax of Rs 12.436 billion in FY04. Also, its average equity capital for FY03 and FY04 was Rs 31.248 billion. Thus, Infosys' RoE in FY04 was 39.8% i.e. Rs 12.436 billion divided by Rs 31.248 billion.

Thus, RoE, when used correctly, can easily measure the management's capability on the three fronts-

Profitability (PAT/Sales),
Asset management (Sales/Assets), and
Financial leverage (Assets/Equity)

Why is it so? Profitability is a function of how efficiently a company is able to employ its capital, utilise its assets and more importantly, sell its products.

What we are trying to say here will be made simpler when we break down the calculation of RoE into these three parts. As such, RoE can also be calculated as:

Return on Equity=(PAT/Sales)*(Sales/Fixed Assets)*(Fixed Assets/Equity)

Return on Equity = Profit margin * Fixed asset turnover * Leverage

This way, not only can investors acquire an excellent sense of whether they will generate adequate return on equity but they also get a sense of the management's ability of running the organisation towards the path of higher growth.

Lets take Infosys as an example and begin with the 'profitability' part.

RoE and Profit margins

Profit margins are, most importantly, a measure of the company's pricing power. Consequently, pricing power is a function of:

Competition: The price a company can charge its customers depends a lot on the level of competition that it faces. Higher the competition, higher will be the bargaining power of customers and thus, lower will be the pricing power.

In the case of Infosys, rapidly increasing competition from both domestic and global technology services providers has affected the billing rates (read prices). Over that, since offshoring is becoming mainstream, more and more clients are demanding finer rates thus leading to lower billing rates for Infosys.
Quality of offerings: When competition increases, a company can still charge higher for its products if it moves up the value chain. And this has been made possible by Infosys' rapid move up the software value chain (like package implementation and IT consulting) to its clients -- services that command relatively high billing rates than say software development, maintenance and reengineering.

However, if one were to consider a general trend in billing rates for Infosys, it has been a declining one. This has impacted margins.

Now, apart from this fall in billing rates, another factor that has impacted the company's margins is its aggressive investments in building up physical (infrastructure) and human (manpower) resource base.

While we believe that the scale benefits from these investments are likely to pay in the future, the fact that the company will have to consistently spend towards employees and marketing initiatives. This will affect margins further, though at a slower rate. And this will affect the company's RoE, as it has been the case in the past.

RoE and Fixed asset turnover

Infosys has the highest margins in the Indian software services sector. But, is that enough? Not really. Although margins play a crucial role in influencing the RoE of a company, the sales generated for each rupee of assets also plays a very important role (read asset utilisation).

In the case of Infosys, while decline in margins have affected RoE, the fact that the company has been earning a higher amount for every rupee invested in its fixed assets, has helped it to pare decline in the same (the RoE).

However, this does not compare well with its peers. For instance, in FY04, while Infosys earned Rs 4.7 for each rupee invested in its fixed assets, Wipro earned Rs 6.2 and Satyam earned Rs 8.3. Lower asset turnover for Infosys is a likely affect of the company's aggressive capex levels, which are likely to pay off in the future.

Now, despite having a better asset turnover ratio than Infosys, lower profit margins for Wipro and Satyam have led to lower RoE for these players, as compared to Infosys. Wipro's RoE was 27.5% and Satyam' RoE was a mere 19.3%.

Generating more sales on less assets means tying up of less capital that the business generates in fixed assets. Proper asset management eventually shows up in the form of high profit margins for a company.

However, high profit margins by themselves do not guarantee that shareholders will receive excellent returns on their investments. As such, determining the asset management capability of a company is key to gauging the quality of its RoE.

RoE and Leverage

Leverage (the other name for debt) is a tool finance managers can use to perk up a company's RoE in the short term. They can simply take on more of debt than equity to finance their expansion plans. And wow, what investors see is an improved RoE (since debt is deducted from assets to calculate the value of equity)!

However, over the long-term, the fact that the company has to pay interest on this debt, reduces its profit margins. This acts as a counter to the rise in RoE due to increased debt levels (if the debt is not productively employed).

Thus, investors need to study debt levels of a company, as this would make their understanding of RoE even simpler. In this case, since Infosys has no debt on its books, its RoE tracks the leverage.

However, in case of companies with high levels of debt (those in capital intensive industries like steel and automobiles), the leverage ratio will play a very important role in understanding the RoE.

Is RoE the end of it all?

Not really. RoE suffers from one drawback. As mentioned earlier, a company that takes high levels of debt will show up a high return on equity. As such, 'Return on Invested Capital (RoIC)' and not RoE will be a good indicator of testing the company's efficiency levels.

However, for understanding the value of companies with nil or marginal amounts of debt, RoE is of great help.

By looking at trends in RoE over a number of years and analysing each of its components (as mentioned above), investors will not only get to understand the P&L account, but also to balance this against the much overlooked left and right sides of the balance sheet.

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