Return on equity is a measure that most investors are greatly concerned about as it is a measure of what return the company is able to generate on the shareholders money. While there is no doubt as to its relevance, the return can in itself be broken down into three components to further analyse how these returns were earned and what mainly helped in generating the same. The ratio helps to understand where superior (or inferior) return is derived from, by breaking it down to its components.
How the Dupont works
Dupont breaks down the return on equity into three components with various balance sheet items canceling each other out due to cross multiplication and ultimately yielding profit after tax divided by equity. However in the process, we also do come to know how each item has performed individually. It is calculated as follows:
Return on Equity = (PAT/Revenues) * (Revenues/Total Assets)* (Total Assets/Equity)
Thus one is able to gauge three different points of performance, for the company.
PAT/Revenues: This is the measure of the company's profitability to show what kind of profit margins the company has been able to generate which is indicative in a limited sense of its pricing ability and cost control when compared with its own performance and with the performance of other companies.
Revenue/Total Assets: The asset turnover ratio is indicative of how efficiently the company has managed to utilise its assets. A high ratio as compared to others is indicative of the company being able to put its assets to more productive use as compared to other companies.
Total Assets/Equity: This ratio is known as the equity multiplier. It is indicative of the leverage employed by the company. It shows how much reliance the company has been putting on debt to finance its assets. While we are not suggesting that debt is bad for a company too much of it can put the company in trouble when headwinds get generated in an industry.
Having this basic understanding of what return on equity is, we will now proceed to apply it to various companies in the telecom sector to analyse their performance over the past five years.
Idea Cellular Limited
The company has had to book losses over the past few years and hence arriving at its return on equity for the initial years was not possible. However the Dupont analysis does throw up some interesting observations. The company has turned profit positive over the past two years and has since seen its ROE double during this period. This it has been able to attain mainly on account of an improved asset utilisation due to an increase in its sales over the years. However, the company still has got plenty of potential for improving its performance by laying an emphasis on increasing profits and generating more cash flows to fund its assets internally. Hopefully, in the near term, we may see this happening as the company expands it subscriber base. The most worrisome feature about the company is that it has placed heavy reliance on the use of debt to finance its assets over the past five years.
Bharti Airtel has been the most consistent performer of the lot. The company has significantly improved its performance to become the company with the highest ROE. The company has over the years acquired the largest market share of the total wireless subscribers in India. This is also reflective in its ability to significantly boost its revenues, which has led to better utilisation of its assets. Also, the profit margins for the company have risen significantly. The increase in the company's revenues has been faster than the increase in its assets, which has led to economies of scale that has ultimately reflected in its asset turnover ratio. The good performance is also the result of a judicious mix of debt and equity to finance the assets, which creates a tax shield on interest expense leading to higher profit after tax but at the same time, does not put it in jeopardy, just in case things take a turn for the worse.
The company has had the best performance record for utilisation of its assets. However, this is on account of the fact that the company has not been spending very aggressively on creating assets in the recent past. But of late, the performance of its asset utilisation ratio has trended downwards which could be attributable to the recent acquisition made by the company that has caused its asset base to swell considerably while its sales have not increased in line with the assets.
What's worrisome is the fact that the company has seen a significant decline in its profit margins over the past years. Thus, it has gone from being a company with the highest ROE to one that has the lowest ROE today. The company has another good to it that is it has over the years managed to reduce its financial leverage by reducing the reliance on debt to fund its assets. This is evident from a trailing equity multiplier. The company has had a bad year in terms of profit after tax as they tumbled form Rs 7.1 bn in FY05 to just Rs 698 m in FY06, which has dented its ROE significantly. However this is mainly a result of the integration of Tyco and Teleglobe, which the company had acquired in 2004 and 2005 respectively. As the company manages to turn around the performance of these acquired companies, one can expect to see a rise in its profit ratios and hence ROE.
The company has seen its profit margins erode away significantly, mainly due to the heat that it is feeling form the private players in the Mumbai and Delhi circles where it operates. Although it continues to maintain a dominant position in the fixed line segment, it has not been able to stem the decline in its fixed line connections over the years. It is no wonder then that its profit margins have dwindled. The company has been rather consistent in its asset turnover performance but this is a result of a fall in its revenues and asset base over the years. Also the reduction in equity multiplier which would otherwise have been a good move for the company is in fact turning out to be a disadvantage and concern owing to the fact that its assets have reduced consistently while its share holders equity has only increased marginally. A culmination of these factors is that the company's ROE has come down significantly over the past five years.
Tata Teleservices Maharashtra Limited (TTSL)
The company has been able to improve its asset utilisation on the back of improved sales over the years. The asset base has also increased significantly, which has been again financed by a judicious mix of debt and equity but it does need to exercise caution so as to ensure that its debt to equity ratio does not spiral out of control. However, the company has had negative profits as a result of which, it was not possible to arrive at the ROE.
To sum it all up, Bharti Airtel (although not the best performer individually in all the components of Dupont analysis) has been the best performer over the past five years with the highest ROE amongst the companies compared. Not only has it improved its profitability and asset utilisation ratios, it has also judiciously used the debt to finance its assets. This has helped the company to improve its ROE each year.