Define
Return on equity (ROE) is a financial ratio that measures the amount of net income generated by a company in comparison to the amount of shareholder equity. ROE is calculated by dividing the net income by the average shareholder equity for a given period, usually expressed as a percentage.
What Formula?
ROE = (Net Income / Average Shareholder Equity) x 100%
What Components?
A. Net Income
The net income used in numerator is Net income attributable to common shareholders or parent and not Net income attributable to Group which includes non-controlling interest
Group Net Income for the year = Net income attributable to Common shareholders or Parent + Non-controlling Interest
B. Shareholders Equity - Balance sheet
Shareholders Equity Attributable to Parent = Shareholders attributable to group – Non-controlling Interest
Where Shareholders Equity can be detailed as:
Any other type of reserve shall be added.
Where can I find them - Financial Statement Linkages?
Real Company Analysis
Let’s take example of Pidilite Industries Limited, Indian chemical company engaged in producing adhesives, sealants, waterproofing solutions and construction chemicals to arts & crafts, industrial resins, polymers. The annual reports can be found at https://pidilite.com/investors/financials/
How to Interpret?
ROE is an important metric for investors as it indicates how effectively a company is generating profits from the equity invested by its shareholders. A high ROE suggests that the company is generating a strong return on investment for its shareholders, while a low ROE may indicate that the company is not generating sufficient profits to justify the investment made by shareholders.
However, it's important to note that ROE can be affected by factors such as debt financing and capital structure, so it should be used in conjunction with other financial metrics when evaluating a company's overall financial health.
Comparison can be done in the following ways:
1. Temporal Comparison i.e. time series trend analysis
2. Comparison with Industry benchmark
3. Comparison with Industry Average or close peers / competitors
Remember when we compare ratios against any average it shall be calculated with same formula otherwise it will result in erroneous comparison.
1. Trend Analysis
As can be seen from our example that Pidilite Industries Limited has consistently performing with ROE of above 20% except for 2021 with ROE falling to 19%.
2. Comparison with Industry Average or close Peers:
But if we compare it with average (median) ROE of close peers, we find Pidilite Industries Limited has outperformed them by quite a margin as seen from table above.
It is important to understand that when we compare ratio with peers/competitors the selection of right peers/competitor is very important. Direct competitors which sell similar if not exactly same type of product or service, in terms of functionality and not form, shall only be compared.
What Strategic Implications
Firms that have ROCE consistently above Weighted Average Cost of Capital (WACC) have sustainable competitive advantage. If we take the numerator of the ROCE ratio which is EBIT and break it further, we see it dependent on Price, Volume of product sold or frequency of services rendered and cost of service. Firms that can charge premium price or have lower costs will consistently perform better in terms of ROCE compared to WACC.
How to Forecast?
To forecast ROE we need to forecast Net Income, and Shareholders funds.
Shareholders Funds
To forecast shareholder’s funds we divided it into its key components:
1. Share Capital
2. Treasury Shares
3. Additional Paid-in Capital
4. Share Premium
5. Reserves
6. Retained Earnings
1. Share capital can be forecasted using straight line method. If you want to get complex, then use additional funding requirement schedule. We need to create and 3-statement model to create such a schedule.
We need to assume about what Debt equity ratio to find additional share capital or debt. We can also use the optimal capital structure model to forecast it.
1. Treasury Shares: Treasury Shares are buy-back of shares by firms. To forecast it we can use either straight line method or look at for clues in annual reports Management Discussion & Analysis part where they discuss their plan for buy-back. But it more likely than not firms do not announce it in advance as it influences stock markets.
2. Additional Paid-in Capital: Additional Paid-in capital is additional capital raised by companies. This is similar to share capital we do not need to forecast this and use the share capital schedule.
3. Share Premium: If you have additional capital and assume to place at premium forecast, it using share capital requirement and premium that you will charge per share. Otherwise, use straight line forecast.
4. Reserves
Reserves are divided into three types:
a. General Reserve: Profits retained in business
b. Specific Reserve: Like Debenture Redemption Reserve are type of reserve is maintained for a specific purpose
c. Capital Reserves: Reserves created for specific purpose and can be used for that reason only
Use straight line method to forecast reserves if details about specific purpose for which reserves were created not available.
5. Retained Earnings
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