Gainful returns

The return on equity (RoE) reflects the productivity of the capital invested in a firm. It calculates how much return a company generates on every unit of the shareholders’ equity, that is, the share capital invested in the company. It is expressed as a percentage and is calculated as the net income (profit after tax minus preference dividends) divided by the shareholders equity (the difference between total assets and total liabilities).

Also known as return on net worth (RoNW), it represents the value of business for its shareholders after it has met all its financial obligations. It is influenced by several factors such as the company’s earning power, its debt-equity ratio and tax rate.

High on return ratios

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Guru Mantras
Most money managers prefer an RoE of more than 15%. Investment guru Warren Buffett favours companies where the RoE is more than 22%, and rising every year. The David Dreman way is to consider RoEs of over 27%. In his book The Warren Buffett Way, Robert Hagstrom Jr. wrote, “The most important management act is the allocation of the firm’s capital...the allocation, over time, determines shareholder value.”

The Cons
Judging a company’s performance using only the RoE can be misleading at times. This is because companies in the FMCG and IT sectors require very little capital and often have high RoEs. Colgate, Nestle and HUL, all have RoEs of more than 100%. Capitalintensive industries like steel and infrastructure often have low RoEs as they require a large capital base. Suzlon’s RoE is 6% and Reliance Natural Resources’ is 4%.

Low on return ratios

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Combined Ratio
To account for different capital structures, RoE can be used with return on capital employed (RoCE). To calculate RoCE, the earnings before interest and tax (EBIT) is divided by the total capital employed in a firm, minus the sum of share capital, reserves and debt. As debt is included, it enables a uniform comparison across leveraged as well as unleveraged firms. A firm’s RoCE should be more than its borrowing rate. If it is less, it implies that the business is unviable.

RoCE = (Earnings before Interest and Tax) / (Shareholders’ Equity + Debt)

Points To Ponder

• A high RoE means that the management has allocated capital in a more efficient manner. It is always preferable if the net income grows in relation to the shareholders’ interest in the company.
• A business that has a high RoE is also more likely to be capable of generating cash internally. In fact, due to the high predictability of cash flows, most FMCG companies trade at a premium to the general market.