Calculating return ratios have been taught to us since eternity. The Difference is some people calculate it, while some use this as a starting point and decode the reason behind movements in the ratios.
Ratios are outputs. Business operating parameters like costing, revenue mix, capital structure mix etc are essentially the inputs that drives the ratios/outputs. Hence looking at what has caused ROE to go up or down is the essential Element in the world of business analysis.
Return on Equity aka ROE is simply defined as the profits generated by a company on the shareholder’s equity. The standard formula to calculate ROE is as follows:
Return on Equity = Year end Net income (PAT) / Average Shareholder total equity
Shareholders equity accounts for Share Capital + retained earnings + Reserves & Surplus (Preference Equity, ESOPs, Convertible debt are ignored while taking Equity). Also before IND AS (Pre-FY18) where other comprehensive income was shown in equity portion we need to exclude that also.
A lot of analyst calculate ROE on beginning equity as they believe that closing equity also account for the PAT generated for the year, where as it was actually beginning equity which helped us generate the PAT of this year.
Our take is you can use both just be consistent in calculating the ROE. The second method of calculating ROE on beginning equity makes more sense when the company has gone for a major QIP/fresh issue of capital around the year end (last quarter) as this capital must be lying ideal in bank accounts and would not have been utilized to generate any meaningful revenue/PAT for the current year.
ROE can be further broker down into 3 sub-parts. The standard Du-Pont Formula (DuPont was an accounting firm that came up with this breakup of ROE.) This breakup will explain us due to which business factor the ROE is increasing/decreasing. Let's briefly talk about interpreting ROE through this:
Return on equity (DuPont)
What is the relation between these components and how is it related to ROE?
The DU-Pont formula in its original sense simply explains the “Operating cycle” of a business.
To understand this let's shift the formula a bit and re-write it:
Financial Leverage (Total Assets/ Total Equity) *Asset Turnover (Total Revenue/ Total Assets) * Net Profit Margin (PAT/ Sales).
Step 1: Imagine company raised total capital of Rs.100 (80% Equity and 20% Debt) and purchased asset of Rs.100
Financial Leverage = Capital / Equity or Assets/Equity = 100 / 80 = 1.25 i.e. for every Rs.1.25 of assets on balance sheet Rs1 of asset has been funded by equity and Rs.0.25 has been funded by debt.
Step 2: Now Company uses that asset to produce & sell goods
Assume the assets purchased by the company produces goods worth Rs.135 which will be sold by the company in the market.
Asset Turnover = Revenue / Assets = 135 / 100 = 1.35 i.e. Rs. 1.35 of revenue generated per Rs 1 of assets
Step 3: Calculating Profits from Revenue
Imagine after all the operating expenditure, interest and Tax expenses the company has Rs.27 left as profit.
Profit Margin = PAT/Revenue = 27 /135 =20% i.e. Rs. 0.2 profit per Rs. 1 of revenue
Now if an investor wants to know how much return does this business has generated for shareholder so the steps he'll follow is:
1) Calculate the amount of equity money/shareholder's money invested in the business
2) Divide Profit left with him with the money he invested so he'll get 33.75% (27/80).
Now if you look at the Dupont Formula carefully you'll find that’s exactly what Dupont was trying to communicate and that's why DuPont elaborated this formula so that those who use ROE can know the core reason why and what is the root cause of the ratio's movement. Is it because company's margin expansion/ Asset turnover expansion or is it due to the leverage (More debt component in Capital structure)
ROE Du-Pont = 1.25 * 1.35 * 20 = 33.75%
You need to understand why this ratio is the most tracked, most useful and according to great investors it is the single important metric an owner should track - because ROE is the essence of running a business - you invest your capital and you want money in return for it - that's the entire essence of trade & commerce.
Please read our Valuation series post and watch our YouTube Video to understand that valuation multiples of a business depends to a great extent on economic profits generated (ROE > Cost of Capital). As a high ROE company requires less reinvestment for growth resulting in higher Free cash flows leading to higher valuation multiples.
An important thing to remember here is that Du Pont analysis was made to guide you whereas we have seen people taking this as the end.
It's not enough to state that ROE has increased because net profit margins increased or asset turnover increased - that's highly superficial analysis. The real essence is now digging deep to understand what business decisions or business characteristics lead to this increase of Margins or Turnover.
It's only when you know the reason behind movement of ROE you will be able to judge it's sustainability.
We Recommend drawing a ROE Tree that decodes ROE to it's last portion. See the image below:
The ROE tree is used to figure out the main numbers that has caused the movement in ROE. The main reason of Increase in ROE as we would all know by know is
1 - Increase In Net Profit Margin
2 - increase in Asset Turnover Ratio
3 - Increase in Leverage
Now digging deep basically means let's say if ROE of your company increased due to increase in Net profit Margins you go into further break up of what was the cause behind this. Common Sizing the P&L statement will help here - basically check which cost has gone down as a % of revenue that lead to increased margins. Also focus on which margins have reacted the most - has the change come at gross level (Gross Profit Margin), EBITDA Level, EBIT Margin or directly PAT Margin has changed. That's why below net Profit margin in ROE Tree we have provided the common sized P&L proforma.
Similarly if total asset turnover has increased where has improvement come from - Fixed Assets turnover or working capital turnover. Now if working capital turnover has increase we need to further break down into where has improvement come from - debtor turnover or inventory turnover or payables turnover.
But to a serious practitioner even this seems superficial. Lets say you end up concluding that ROE increased due to increased in EBITDA margins because operating cost as a % of revenue reduced. A serious practitioner will ask you what change in business model actually happened that lead to decrease in Operating cost? That's the real question. You go from numbers to business to dig out the real cause of movement behind ROE.
Below are few of the reasons that may causes shift in PAT margins of the company. Before we proceed to the list please understand that some causes behind margin movement will be affecting ONLY a specific margin like Value added Product Vs Commodity Products basically directly affects gross margins and that leads to a change in PAT margins. Whereas there are some reason that affects margins at multiple levels for example Manufacturing Vs Trading mix of the company affects both gross margins (manufacturing generally has higher gross margins than trading) & EBIT margins (due to asset light model and lower depreciation in Trading). We have provided below few case studies with causes of margin movement:
a) Product Mix - Higher portion of valued added product Vs Commodity products can enhance your margins. Example : Garware Technical Fibers
b) Manufacturing Mix - Manufactured Vs Trading/Outsourcing Mix - Generally speaking Manufacturing has higher Profit Margins as compared to trading/Job work revenue. As companies which use this bi-model of manufacturing & trading generally prefers to manufacture complex value added products in-house and outsource products of commodity nature. Example: Cera Sanitaryware
c) Raw Material Pricing, Pricing Power & Passthrough contracts: Gross margins of a company are affected various relationships between Raw Material Pricing and Final Product Pricing. See some of the relationships below:
i) Increase/Decrease in RM cost is passed on to consumer in absolute amount: Increase in RM in these scenario will lead to decrease in margins even after pass on - Vinati Organics (Cost+ Approach) or Deepak Nitrite. Imagine Finished products prices are 500 and raw material cost in 200 leading to gross profit of 300 i.e. gross profit margin of 60%. Now Raw material prices increased by 100 and due to cost+ model we passed on this 100 to final buyer. Now the prices of Finished goods in 600 and raw material cost id 300 leading to gross profit of 300 (which is same as earlier) but the gross profit margin comes down to 50%
ii) Increase in RM cost is passed on to customers in % amount (Passthrough contracts): Margins will be maintained here - Case in Point PI Industries or IT companies having Time-and-material based contract rather than fixed price contracts.
III) Increase in RM cost is difficult to pass to customers or pass through happens with a decent lag: Leads to Decrease in gross margins in increased RM environment - Case in Point Avanti Feeds
IV) Decrease in RM cost actually results in more than proportional decline in Final Product pricing ( a very unique scenario indeed): Case in Point - Kukoyo Camlin (Due to nature of competitive intensity from unorganized sector)
d) Economies of Scale: In some industries where bargaining power of supplier is weak buying in bulk can reduce the cost of material sold for the company. This leads to a lower COGS % of revenue sold which leads to higher gross profit Margin & Vice Versa. Economies of Scale also leads to reduction costing too - Case in Point: Divis labs - It is basically among the top 3 API players of the world & largest of India. The margins of Divis labs are uncomparable to any API players in the country because if their strategy to pick up a scale in the major molecule they enter. Out of total approx 120-130 APIs developed by Divis it is the world’s largest manufacturer in more than 10 Generic APIs including products like Naproxen, Diltiazem and Dextromethorphan. Divis actually accounts for over 50% of global production of these molecules. Cost efficient Bulk Production: For this Divis follows a particular theme - they carry huge inventories on balance sheet - They manufacture batches of the same product in sequence for large volume products like Gabapentin, Naproxen & Dextromethorphan by running the plant at full capacity and stock these products as inventories for sale. This doe two things producing in bulk reduces cost, frees up the multipurpose plants for producing other products but carries significant volume of inventories on balance sheet.
e) Bargaining Power of Buyer: Case in point - Garware technical Fiber - Being in niche product categories, the number of customers are limited. Hence, Bargaining power of customers is very high especially as the product prices are generally more than a million dollars per item. But next angle is Garware’s products like nets and ropes typically do not form a significant portion of the overall operating costs for the end-user.
In the case of aquaculture, fish feed accounts for nearly 50% of total operating costs whereas net cages constitute under 10% of the total cost. Similarly, for fishing trawlers, diesel which is used to power the motor accounts for >50% of the total operating cost. (Cost break up credit: Marcellus Spotlight story on Garware)
Ps: See sometimes you even get such contradictory situation where on one side value added & commodity break up of Garware should tell you that margins of the company should increase as company today generates 65-70% of revenue from value-added goods which is exactly the reverse of what was around a decade back where 65-70% of revenue was from commodity products. Whereas bargaining power of buyer shows that the margins of the company should not increase as buyers have power to negotiate pricing. In such scenarios we should have a net-net mindset. As Garware is able to come up with new value-added products (40-45patents have been filed so far over the years) they are able to charge premium for their products hence diluting the effect of Bargaining power of buyer.
f) Change in business model/strategy: Case in Point - Hester Bio: Moving away from tender based business (fixed margins) to Distribution focused business (more pricing power) leading to enhancement in margins of the company.
g) Backward Integration: Backward integrations means yo are able to source your own raw material requirement. The way it affects margins is it less costly to use that raw material as middleman margins are removed. But backward integration is not not limited to raw material front. It may also mean Company backward integrating to reduce some operational cost like Cera Sanitary ware did with packaging cost or Mold-Tek packaging did with in-house Moulds, robots, and labels (major inputs required in this industry) while competitors majorly do imports.
When we particularly talk about raw material backward integration we need to understand that till what level is the chain integrated. For example in chemicals there are broadly three legs KSM (basic commodities) -> Intermediates - > formulations (this is the simplest version of production chain). Hence when a formulation companies says it is backward integrating we need to understand whether it is till intermediate level or KSM level.
As the real risk in raw material price comes from KSM price movements. Companies like Aarti Industries which are fully integrated from the first step of the value chain (in their main products like Benzene) are able to manage margins well in fluctuating raw material environment.
Whenever a company files their capex its mandatory to visit capex details. Their are various sources through which we can find out details regarding the same. For example in chemical companies check Environmental clearance documents (environmentclearance.nic.in ), in Cement companies check parivesh.nic.in and mines.gov.in ).
h) Change in RM mix of the company: Case in Point PVC Pipe Industry: Raw-material for plastic pipe i.e., PVC resin and additives together account ~70-75% of the total COGS. In India, ~ 56% of the total demand of PVC resin is met through imports. There are limited domestic resin suppliers. One of the largest domestic resin suppliers is Reliance.
Unlike large players who enjoy 4-8% discount by procuring resin from Reliance or by directly importing from international resin manufacturers, small players procure resin from importers or distributors by paying a premium of 2-3%. Due to this, large players enjoy a cost advantage of 6-11% over small players.
I) Cheaper Manufacturing Processes/Cost Controls : Case in Point - Cement industry. Power & fuel cost is either the highest or the second highest cost in P&L of a cement company. Now cement being a commodity product it become very essential to control cost. The power & fuel cost on a per ton basis across cement companies is dependent on variety of factors like: Total Waste Heat Recovery System as a % of total power requirement (WHRD reduces power cost), Solar and Wind power % - given the low cost of production, 3) Use of Low cost industrial waste to use to heat plants 4) % use of Pet-coke in overall mix (pet coke is cheaper than coal but reduces plan shelf life leading to high maintenance expenditure) 5) Pet-Coke and Coal Prices 6) % Captive Power (captive power cost on a per ton basis is lower than power sourced from external supplier)
J) Efficient Technology Leading to Efficient production Cycle: Case in point being APL Apollo tubes when in the year 2018-2019 they launched Direct forming technology in India for making hollow section of rectangle and square under EWR steel pipes category. Broadly speaking this technology reduced their production time frame from 1 day to approx. 30 mins leading to huge saving in inventory cost (as no need to store as much inventory now). It also lead to less wastage in material cost by approx. 5%. It also allowed the company to produce hollow sections of various sizes (thickness, dimension etc.) with even low quantities like 100-200 pipes while earlier the company had to produce in large batches of size 10,000-15,000 pipes to keep costing low and production efficient. Along with these entering more value added products lead to good margin expansion.
K) Your trade channels and distribution channels can affect your margins: AMC garnering more AUM through direct options & their own banking channel have more margins that AMC who are more dependent on external wealth managers/distributors. In cement similarly your break up between channel sales (company->distributor-> retail customer) Vs Direct sales (directly to big real estate & infra players) will determine your margins (there is more margins in channel sales than direct sales)
L) Hedging: Hedging is also a driver of gross profit margins especially if your company is not naturally hedged. Natural hedging means that if you export goods worth 100$ you also import goods worth $100 (Same amount same foreign currency). If you are not naturally hedged, management decides what % of revenue exports or Raw material imports do you want to hedge. Some companies prefer partial hedge, for example if you are importing goods worth 100$ you hedge for 50$ against Dollar depreciation - as dollar depreciation hurts importers. Some companies may prefer to remain completely unhedged making themselves vulnerable in short run to currency fluctuation. This especially happens sometimes in companies with decent share of export proportion in revenue - case in Point being: VIP industries & Vinati Organics.
M) Regulatory Influences: Pick sugar industry for example the pricing of raw material i.e. sugarcane is government dependent and hence a revision is government MSP rates of sugarcane leads to direct impact in gross profit margins of the companies. Take another example of AMC industry where expenses ratios are revised & fixed as per AUM by the regulatory body AMFI (Technically speaking yes AMC's don't have a gross margin but you get the gist). Fixation of ROEs at 12% for PSU Power Distribution companies by Government of India.
N) Inventory Gains: A lot of times in commodity companies once they manufacture the inventory, the prices of finished products shot up a lot leading to huge increase in realizations. Basically the COGS is at cost (historical levels) and price of final products is at current inflated levels leading to huge increases in margins. This scenarios happens across industries especially textiles, sugar, PVC resins suppliers etc
O) Accounting Change: IND AS 115 or IND AS 116 affecting revenue recognition or cost reporting affects margins. Case in Point - Mahindra Holidays - IND AS 115 or logistic companies/QSR industry or HCG for IND AS 116.
P) Sources of Revenue - The source from which revenue is being generated also affects Gross margins. For example Segmental break up: ITC EBIT margin's structure Cigrate EBIT margin>FMCG EBIT Margin>Agri EBIT Margin > Hotel EBIT Margin geographical change: MDF industry Lower realizations in Exports Markets Vs Domestic Market or Tiles industry lower realizations in Exports Markets Vs Domestic Industry.
Q) Operating Leverage/Proportion of Fixed Cost Vs Variable Cost in the business - please read our detailed post on how operating leverage affects margins of a company
R) Economic Life Vs Accounting Useful Life of asset: In some industries assets are depreciated at a much faster rate due to companies Act, 2013 guideline whereas actual usage of those assets continue for much longer period of time. The essence is the cost of using those asset (depreciation) goes away but still those asset keep on generating revenues for the company leading to expansions in margins. Case in Point: Crane Industry, Hospital Industry, Amusement Park Industry, Hotel Industry
S) Capital structure Mix: A company which is deleveraging its balance sheet will seer decrease in it's interest cost leading to increase in margins and vice versa. Case in Point D mart
T) Tax Structures & Tax Zones: Companies expansions plans in SEZ zones/Tax holidays-Tax exemptions structures/ Tax Loss carryforwards/Shifting to lower tax regimes/International transfer pricing issues also affects the margins of the company. Case in Point SEZ: PI industries consistently low effective tax rate than regulatory environment. Tax exemptions Case in Point: IT industry leading to low tax rates. Tax loss carryforward: Case in Point: Punjab Chemicals. Shifting to lower tax regime: Avanti feeds. Transfer Pricing Issues: Affle/Route Mobile
U) Industry Consolidation: During downturn in industry lot of small players get swiped off reducing the supply in the industry and indirectly due to shortage of finished goods leads to huge increase in prices of finished products and also as smaller players exit the market share gets consolidated between few large & medium organized players. Firm pricing on product side leads to increase in margins of the existing players. Case in Point: Real estate (2021-2022), PVC pipe industry (2021-2022), Cement industry etc
We can fill V,W,X,Y,Z too!!!!!! but we hope you get the gist. Just commenting ROE has increased because margins have increased without understanding the actual reason behind those
Similarly there are various reason for both Fixed Asset turnover and working capital turnover to increase. Below we are just pointing out the reasons (avoiding the explanation else this blogpost will have to be converted into a book and will have to be sold in stores near you 😂😂😂)
Fixed Asset Turnover can be explained by:
a) Manufacturing Mix (In-house Manufacturing Vs trading/outsourcing)
b) Economic Life Vs Accounting Life
c) Long Asset Commercialization Cycle/Long CWIP cycle: Look at companies like ONGC which has three tier transfer of assets on balance sheet leading to long gestation period before assets are finally used for revenue generation.
d) Life stage of a business (Requiring consistent capex due to unmet/sudden Demand/Long structural story)
e) Capacity Utilizations: Greenpanel turnover due to high realizations and 100% capacity utilizations in FY16/FY 17
f) Type of Capex - Greenfield/Brownfiled/De-bottlenecking
g) Shift towards Asset Light model
h) Efficient process/Economies of scale
Working Capital Turnover movement can be due to: a) Inventory turnover, b) debtor turnover and c) Payable Turnover
We also need to understand that Calculating ROE for a single year does not make any sense. An analyst needs to analyze
Trend of ROE over past 10 years
Analyze causes of movement in ROE over past 10 years
Longevity of High ROEs - Will current levels be sustainable in future or increase further or decline from here
If ROEs are low Currently - will they increase from here or will remain low perpetually
Are industry wide ROE depicting any cyclical patterns - understand the range of ROEs during a business cycle
ROEs comparisons with listed peers and understanding the reason behind better or worse ROEs as compared to peers
Trend of relationship between ROE, Re-investment rates and Free Cash Flows.
Sometime ROEs may not reveal the true nature of the business. There are lot of adjustments that may be required to take into account while calculating ROE. For example:
a) Adjusting ROE for some heavy Expansion recently done: Wonderla Holidays FY 17
b) Adjusting equity for some major buybacks or FPO/QIP or IPO money being raised for Y-o-Y comparisons: PI Industries FY 20 - FY 21
c) Adjustments for impacts of accounting changes particularly IND AS 115 Revenue change or AS 8 change of asset recognition for making 10 year trend comparable: Mahindra Holidays
Please read our blog here on the same
d) Focusing on Segmental ROE in case of De-mergers: Suven Life Sciences ltd.
e) Adjusting for one off gains - Aarti Industries Q3FY 22 630 gains results
f) ROE Cycle Average in a Cyclical Company: SAIL
Look at the same company from FY 17
g) Caps Put forth in some regulated sector like PSU Power Grids where upside is capped at 12% - Power Grid Corporation Limited/NTPC
h) Standalone ROE Vs Consolidated ROE: Tata Steel
I) Core ROEs Vs Non Core ROEs: TVS Motors
Look at consolidated ROCE of TVS motors in the last two years
Look at standalone ROCE of TVS Motors in the last two years
Standalone cash flow statement of TVS Motors - specifically look at the two line items of Loans & advances and proceeds from borrowing
Consolidated cash flow statement of TVS Motors - again look closely at the loans & advances and borrowing section:
The moot point is the list is endless and ROE/ROCEs need to be judged on case to case basis. A simple bread/butter analysis of even Du-Pont ROE does not work if you really want to understand a business.
Standard academics teaches that ROE should be majorly used for the companies which have major equity components as we saw above ROE can be easily propped Up using Debt.
Even though that's technically correct banks, steel etc functions majorly on debt an investor should track their ROE because the unit economics of such businesses make sense if they are run majorly on debt due to asset intensity or re-investment requirement. A businessman does this business only because he knows he will make good ROE due to tremendous leverage allowed.
There are lot of variables that needs to be looked forward to while move towards ROE Vs ROCE vs ROIC debate. Please read our next Blog - Blog 113 - ROE vs ROCE vs ROIC Vs ROIIC - "yeh rishta kya khelata hai Kahani ghar ghar ki"