What do you look at while analysing a company?

Do you invest in a company because of its sea facing office?

Or because the CEO drives luxury cars?

I believe the answer is a loud No!

Return on Equity (ROE) is the first thing an investor must look at while analysing a company. It is the returns earned by investors for every unit of invested capital. ROE ratio is one of the most important financial ratios used by investors worldwide to analyse stocks. It helps them understand how much profit a company is able to generate for its equity shareholders.

Knowing this is important as equity shareholders aren’t the only investors in a company. A company also raises capital via preference shares and debt. Creditors and preference shareholders have the first claim on a company’s profits. Whereas equity shareholders are paid last.

Hence it is important for equity shareholders to understand how much value a company is creating for them. This is exactly what return on equity tells them.

For example: The ROE of Reliance Industries is 10.20%. This means the company is generating 10.20% returns for its equity shareholders.

But wait … Is this ROE good or bad? What is the ideal ROE ratio? Does a high ROE always mean a profitable investment? These are some of the questions that we will answer in this article. 

We will also cover the following:

• What is ROE? – Return on Equity Meaning
• How to Calculate ROE? – Return on Equity Formula
• How to Avoid Manipulated ROE
• Return on Equity using the DuPont Model 
• List of Companies with Highest ROE
• List of Companies with Highest ROE to avoid

Let’s Begin with What is ROE?

What is ROE? – Return on Equity Meaning

Return on Equity is one of the most important profitability ratios. It measures a company’s ability to generate returns on assets for its equity shareholders. Higher ROE is a positive sign for investors. It means the management is able to generate higher returns on its stockholders equity. .

Let us understand what is ROE with this simple example. You want to buy a car costing Rs 5 Lakhs. You plan to run the car in Ola/Uber for some passive income. You have Rs 3 Lakhs and borrow the remaining Rs 2 lakhs from a friend. In the first month, you make a profit of Rs 20,000. Let us calculate your ROE.

To calculate ROE, you need to divide net profits by shareholder’s equity. In the above example, your ROE is 6.66% (Rs 20,000/ Rs 3 Lakhs)

Now imagine if you only had Rs 2 Lakhs and borrowed Rs 3 lakhs from your friend. Your new ROE is 10%. Note the relationship between debt and return on equity. ROE increases with an increase in debt.

Types of ROE Ratios – Return on Equity Types

There are two types of ROE ratios:

• Return on Total Equity
• Return on Common Equity (Generally preferred)

Return on total equity includes preference shares. Preference shareholders are paid before common shareholders. Hence return on total equity shows an incorrect picture.

For example: ABC Ltd has a total capital of Rs 10 Lakhs from the following sources –

• Common Equity Capital – Rs 4,50,000
• Reserves and Surplus – Rs 50,000
• Preference Shareholders – Rs 2,00,000
• Creditors (Debt) – Rs 3,00,000

It pays 10% interest on loan. Dividends @15% is paid to preference shareholders. The company generates an operating profit of Rs 5 Lakhs in the first year. Let us calculate both total and common return on equity. 

Notice that return on common equity is higher than return on total equity. This is because we have deducted dividends paid to preference shareholders. Since you are buying common equity stocks, always consider return on common equity.

ROE Formula – Return on Equity Formula

ROE Formula = Net Income / Shareholder’s Equity

Net income is the actual income generated by the company after paying interest on debt and dividends to preference shareholders. It does not include dividends paid to common shareholders. It is available in a company’s profit and loss statement (P&L).

Shareholder’s Equity = Share Capital + Reserves. It is available in a company’s balance sheet.

[Read More: How to Read a Company’s Balance Sheet]

Let us use the ROE formula to calculate the Return on Equity of Hindustan Unilever Ltd (HUL). Below is the P&L statement for March 2020.

It’s net profit for March 2020 is Rs 6,748 Crores. Let us calculate shareholder’s equity using the below balance sheet.

Shareholder’s Equity = Share capital + reserves and surplus

= Rs 216 + Rs 8,013 Crores

= Rs 8,229 Crores.

ROE of HUL Ltd = Rs 6,748 Crores / Rs 8,229 Crores = 82%.

[Check out: Should You Invest in HUL Ltd?]

Now you must be thinking that HUL’s ROE of 82% is superior to Reliance Industries ROE of 10.20%. Hence its common sense that HUL Ltd is the superior stock. By this logic, Gian Life Care Ltd has an ROE of 1,027%!

So, is this the best stock in India?

The answer is No!

Investors shouldn’t get too excited with high ROE stocks. A high ROE stock can simply be a result of very high debt. Investors should ideally avoid companies with exceptionally high ROE and Debt to Equity (DE) ratios.

What is the Ideal ROE ratio? – Ideal Return on Equity Ratio

There is no universal ideal ROE ratio. Return on equity ratio differs from industry to industry. For example, the average ROE of 30 Sensex stocks is 20.67%.

Here is sector-wise average return on equity: 

While there is no ideal ROE ratio, average industry ROE is a good benchmark for investors to use while analysing stocks.

A good habit is to analyse a company’s ROE ratio for at least five years.  A constantly increasing ROE ratio is much better than a sudden spike in ROE. In fact, companies with uneven ROE ratios should be investigated further.

Below is the 5-year Return on Equity trend of HDFC Bank Ltd and State Bank of India (SBI). 

• 5-Year return on equity of HDFC Bank Ltd

•  5-Year Return on Equity of State Bank of India.

Notice the high fluctuations in SBI’s ROE. Now compare this with HDFC Bank’s consistent ROE of 18%. Ideally you should avoid stocks with high ROE fluctuations.

[Check out: Which is the better stock? – HDFC Bank or State Bank of India with Samco’s Ratings]

Investors are always searching for stocks with the highest ROE. But ask yourself, ‘at what cost?’ All that glistens isn’t gold. Similarly, even the ROE ratio can be easily manipulated.

Company’s management can easily inflate its return on equity by changing their capital structure. Let us understand ROE manipulation tactics in detail.

ROE Manipulation Tactics

Return on Equity ratio can be manipulated by:

• Increasing Debt
• Share Buyback

1. Increasing Debt: Many companies prefer raising capital through debt over equity. Debt financing is cheaper and quicker. It is also a perfect way to manipulate return on equity ratio.

Let us go back to the earlier example of ABC Ltd. The total capital remains the same Rs 10 lakhs. But there is a change in the capital structure. The debt has increased from Rs 3 lakhs to Rs 5 Lakhs.

By increasing their debt, ABC Ltd has increased its return on equity from 61.60% to 98%!

There is a 59% increase in ROE simply because the company increased their debt. Apart from profits, even high debt can lead to high return on equity. Hence a good practice is to consider the Debt to Equity ratio (DE) while analysing a company’s return on equity. 

The below table consists of companies with high ROE ratios but take a closer look at their DE ratios!

By looking at S.A.L Steel Ltd.’s return on equity of 238.47% you’d think this stock is your ticket to riches. But beware as the company has a high DE ratio. It also has a negative operating earnings and interest coverage ratio.

2. Share Buyback: The primary goal of share buyback is to use the excess cash available for increasing existing shareholder’s value. But it serves a dual purpose. It also consolidates shareholder’s equity. When shareholder’s equity reduces, return on equity automatically increases.

However, this is an artificial increase as net profits remain the same. For example: In 2019, Wipro Ltd initiated a share buyback. Here is its return on equity before and after the buyback.

So, the next time you decide to invest in high ROE stocks, analyse the reason behind the high return on equity. Is high ROE because of high debt or has the company actually earned higher profits?

Luckily, you don’t need to hire a detective to investigate the reason behind high return on equity. The driving force behind high return on equity can be easily ascertained using the DuPont model.

DuPont Model ROE Analysis

DuPont Model is the best way to calculate Return on Equity. It was introduced in the 1920s by DuPont Corporation. It tells you exactly which aspect of the business is driving its return on equity. DuPont model helps investors determine if debt or asset efficiency is the reason behind high ROE

DuPont model works on three parameters –

• Operating Efficiency: Net profit margin measures management’s ability to generate higher sales at lower costs. It is calculated by dividing net profit with total sales. A low net profit margin means an inefficient management.
• Asset Efficiency: This shows the management’s ability to utilise its assets for generating profits. It is calculated by dividing net sales and average assets. Higher the asset efficiency, higher would be the profits.
• Financial Leverage: This shows the amount of debt taken to create assets. It is calculated by dividing average total assets by average equity. 

 ROE Formula using DuPont Model = Net Profit Margin * Asset Turnover Ratio * Equity Multiplier

= Net Profit   *       Net Sales         *   Average Assets

   Total Sales      Average Assets        Average Equity

Consider the below example:

Can you point out the reason behind the increased return on equity? 

All things constant, return on equity went up because average equity reduced. This happens when companies opt for debt financing over equity financing.

How to Analyse Stocks Using ROE Ratio?

Let us now understand how to analyse stocks using ROE ratio. The below table shows the three financial metrics of the DuPont model for the IT industry. Please note that instead of equity multiplier, we have taken DE ratio as it also measures financial leverage. 

Observe the following: 

• Excluding Happiest Minds Technology Ltd, the average return on equity of top 10 stocks in the IT sector is 25.03%.
• TCS is clearly the best stock in the IT industry as seen in its high return on equity, profit margin and low DE ratios.
• Happiest Minds Technologies Ltd has the highest return on equity but its net profit margins are lowest among the top 10 players. A high return on equity backed by high profit margin is acceptable. Unfortunately, that isn’t the case with Happiest Minds Technology.

Notice how the DuPont model helps us understand exactly which aspect is driving ROE. Happiest Minds Technology’s return on equity of 83% seems impressive. But it has a low net profit margin and comparatively higher DE ratio. Such stocks need further investigation.

As promised, here is the list of top rated stocks with highest ROE.

List of Companies with Highest ROE in India

Check the return on equity of stocks in your portfolio by visiting Samco’s Stock Rating Page. As a bonus let me also share high ROE companies that you should AVOID!

List of Companies with Highest ROE to Avoid

This concludes our discussion on Return on Equity ratio. It is just one of the many financial ratios that investors need to study before investing in a stock. 

There are more than 4,500 stocks in the market. Analysing each of them is an impossible task for common investors. Hence, we at Samco have taken the responsibility of handpicking stocks with the best return on equity and 20 million more parameters. Check your stock’s ranking before making any investment decisions.

We at Samco have curated the list of best long-term stocks to buy. One of these stocks has a return on equity of 30%! All you need to do to invest in these stocks is to open a free Samco Demat account.