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.