X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2018 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
How can your company increase its ROE? - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

How can your company increase its ROE?
Feb 9, 2009

This article will discuss the various factors that contribute to making a company capable of achieving a certain level of return on equity. But first, a primer on 'ROE' is in the offing - ROE, or Return On Equity, is the return that a company achieves on its book value. The book value of a company can also be termed as net worth or equity (you may view 'Are stocks at historically low book values?' for a better understanding of book value).

Return on equity can be calculated by dividing the annual profit after tax of a company by its book value during that period. It tells you the rate of return the company is earning on the total funds that shareholders of the company have put in. The average ROE that a business earns over many years can tell you a lot about the profitability of the business. The maintenance of a strong ROE during good times and bad indicates a superior business model employed by the company, and can be a fabulous thing for the investors of the company provided that an exceptionally high price is not paid for buying a piece of that company.

Since it is one of the major drivers for creating shareholder value, it helps to break up and analyse the different factors that can help a company increase its ROE. Analysing that would also help throw light on the various strategies employed by companies to increase their ROE, and the implications of those strategies for the shareholder. We shall use BHEL as an example to illustrate each of the points.

(1) Increasing sales turnover - Sales turnover is the ratio of sales to the total assets employed by the company. It indicates how efficiently the company is using its assets to generate sales. A company can try to perform better on this metric by decreasing the amount of assets it uses to achieve a certain level of sales. The major assets that can be attempted to be used more efficiently by a company are inventories, receivables and fixed assets.

For example BHEL's FY08 sales were about Rs 193 bn while its total assets at the end of FY08 were Rs 307 bn. BHEL's sales turnover comes out to about 0.6 which is slightly on the lower side when compared to some of the best in the engineering industry.

(2) Wider operating margins on sales - For every rupee of sales that a company makes, there are many operating expenses that have to be met before it can arrive at its operating profits. Some of them are employee costs, raw material costs, and other general & administrative expenses. In times of inflation, companies are always on the lookout to try and increase the prices of their products without hurting demand. But the fact of the matter is that inflation causes an increase in its operating costs too. In such a situation, the only way a company can increase its margins and keep them wide is to increase its prices (sales) at a faster rate than the increase in its operating costs. This can be achieved only by way of some competitive advantage the company might posses like being the lowest cost producer, or having a strong brand that lets it raise prices without taking away from the demand for its products. BHEL's margins for FY08 stood at 17.4% which is on the higher side of the industry average.

(3) More leverage - This is one thing a company might resort to if its ambitions to grow are higher than the pace of its internal accruals. Taking up more debt has the effect of enhancing the ROE of the company. But at the same time it exposes the company to certain external risks due to the fixed costs of the interest charged by the lender and the timely repayment obligations of the principal amount according to the preferences of the lender. Thus in general, a company earning a certain level ROE without any debt is much safer and superior than a company earning that same level of ROE by employing big amounts of debt. BHEL has negligible debt on its books.

(4) Cheaper leverage - In times of inflation, interest rates tend to go up. The cost of debt goes up along with that. The more expensive cost of borrowing, the lesser it contributes to improving a company's ROE. In fact, if it becomes inevitable for a company to borrow at high rates of return in bad times, and if the rate of interest is more than the returns the company can generate using those funds, it can actually take away from the final ROE of the company.

(5) Lower taxes - Taxes can take a significant bite out of a company's profits and thus ROE. Thus, some companies in certain industries that are subject to lower taxes due to favourable government policies/incentives have a huge advantage over the others. For example, IT companies have enjoyed lower tax rates (about 12%) for many years due to the government's attempts to encourage investments in the sector. That has helped many IT companies shore up their returns on equity. BHEL's FY08 tax rate stood at 35.5%, indicating that it does not enjoy any such tax breaks.

Equitymaster requests your view! Post a comment on "How can your company increase its ROE?". Click here!

1 Responses to "How can your company increase its ROE?"

N.M.R.Shreedhar

Oct 13, 2010

Interesting reading. I think what has been outlined in this article is called "DuPont Analysis" where ROE is expressed as a product of Net Profit Margin,Total asset turnover ratio and asset-equity ratio. It is a very useful tool in anlaysing a company,especially to find cost reduction areas,increase assset utilisation and also for inter-company comparison. Btw, is it a mere coincidence that Value Research also has a similar article posted on its website? regards

Like (2)
  
Equitymaster requests your view! Post a comment on "How can your company increase its ROE?". Click here!

More Views on News

Two Meetings That Nailed the Idea of Owning Brilliant Smallcaps Without Buying Them (The 5 Minute Wrapup)

Mar 22, 2018

Certain blue chips hold the potential of delivering returns comparable to small-cap stocks. With these stocks, you can get the best of both worlds.

What They Forgot to Tell You About Sensex at One Lakh (Profit Hunter)

Nov 29, 2017

Stocks that could beat Sensex returns in the long term.

How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

Jun 10, 2017

Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

How to Make Money Without Thinking: Lessons from a Nobel Prize Winner (Sector Info)

Apr 26, 2018

Here's an investing strategy that takes human thinking out of the picture, is easier, and profitable at the same time.

To Win in the Stock Market, You Must Win Big. Here's How... (The 5 Minute Wrapup)

Apr 26, 2018

Stocks of companies with strong fundamentals and high-quality management will stand to gain spectacularly in the long run.

More Views on News

Most Popular

Why India is Short of Cash Again(Vivek Kaul's Diary)

Apr 19, 2018

It is basically a supply problem with not enough currency going around in the financial system.

A Sure Shot Way to Predict a Multibagger Stock(The 5 Minute Wrapup)

Apr 17, 2018

The imaginary stock price of IIM Ahmedabad could have rivalled the returns from Titan and Asian Paints thanks to its enormous pricing power.

Why Buffett Would Scowl at My Latest Recommendation...(Profit Hunter)

Apr 18, 2018

Warren Buffett's advice that may not be so relevant in these dynamic times, and could do investors more damage than good when taken at the face value.

This is How a Smart Robo-Advisor can Help You Chart Your Asset Allocation...(Outside View)

Apr 16, 2018

PersonalFN explains how a dependable robo-advisory platform can help you create your personalized asset allocation plan

How Retail Investors Often Dump the Best Buying Opportunities(Chart Of The Day)

Apr 16, 2018

A journey into how retail investors have invested since the turn of the millennium and why I don't want to do repeat that mistake ever again...

More

Small Investments
BIG Returns

Zero To Millions Guide 2018
Get our special report, Zero To Millions
(2018 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Apr 26, 2018 (Close)

MARKET STATS