One ratio every investor must understand - Views on News from Equitymaster

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

## Legal

• MyStocks

 (Please do not use this option on a public machine)

 Select (Optional) Equitymaster Flex Equitymaster Reserve Exponential Profits Hidden Treasure Forever Stocks Microcap Millionaires Double Income Permanent Wealth Circle Phase One Alert Portfolio Tracker StockSelect Weekly Cash Alert Fast Profits Report Alpha Wave Profits Wealth Alliance DeriVantage TradeMaster Equitymaster's Secrets OptionMaster Learning Forum

# One ratio every investor must understand

Aug 25, 2009

Return on Equity (RoE) ratio is one of the most important ratios that every investor must understand. This is because it is used to measure the efficiency with which a company utilises the equity capital. In this article, we shall discuss what RoE is and how it is calculated with the help of an example.How is RoE calculated?
RoE is calculated by dividing the 'profit after tax' earned in an accounting year with the 'equity capital' as mentioned in the balance sheet of the company. Let us take the example of Infosys. The company earned a profit after tax of Rs 59,880 m in FY09. Also, its average equity capital for FY09 was Rs 182,540 m. Thus, Infosys' RoE in FY09 was 32.8% i.e. Rs 59,880 m divided by Rs 182,540 m.

 Data Source: Company, Equitymaster Research

Thus, RoE, when used correctly, can easily measure the management's capability on the three fronts -

1) Profitability (PAT/Sales),

2) Asset turnover (Sales/Assets), and

3) Financial leverage (Assets/Equity)

What we are trying to say here will be made simpler when we break down the calculation of RoE into these three parts. As such, RoE can also be calculated as -

Return on Equity = (PAT/Sales) * (Sales/Assets) * (Assets/Equity)

OR

Return on Equity = Profit margin * Asset turnover * Leverage

Let's take Infosys as an example and begin with the 'profitability' part.

RoE and Profit margins
Profit margins are, most importantly, a measure of the company's pricing power. Consequently, pricing power is a function of –

1. Competition: The price a company can charge its customers depends a lot on the level of competition that it faces. Higher the competition, higher will be the bargaining power of customers and thus, lower will be the pricing power. In the case of Infosys, rapidly increasing competition from both domestic and global technology services providers has affected the billing rates (read prices). Over that, since offshoring is becoming mainstream, more and more clients are demanding finer rates thus leading to lower billing rates for Infosys.

2. Quality of offerings: When competition increases, a company can still charge higher for its products if it moves up the value chain. And this has been made possible by Infosys' rapid move up the software value chain (like package implementation and IT consulting) to its clients – services that command relatively high billing rates than say software development, maintenance and reengineering. However, if one were to consider a general trend in billing rates for Infosys, it has been a declining one. This has impacted margins.

Now, apart from this fall in billing rates, another factor that has impacted the company's margins is its aggressive investments in building up physical (infrastructure) and human (manpower) resource base. While we believe that the scale benefits from these investments are likely to pay in the future, the fact that the company will have to consistently spend towards employees and marketing initiatives. This will affect margins further, though at a slower rate. And this will affect the company's RoE, as it has been the case in the past.

 Data Source: Company, Equitymaster Research

RoE and Asset turnover
Infosys has one of the highest margins in the Indian software services sector. But, is that enough? Not really. Although margins play a crucial role in influencing the RoE of a company, the sales generated for each rupee of assets also plays a very important role. In the case of Infosys, while decline in margins have affected RoE, the fact that the company has been earning a higher amount for every rupee invested in its fixed assets, has helped it to pare decline in the same (the RoE).

However, this does not compare well with its peers. For instance, in FY09, while Infosys earned Rs 0.98 for each rupee invested in its assets, TCS earned Rs 1.23. Historically, Infosys has had lower asset turnover as compared to its peers. This is mostly due to the company's aggressive capex levels.

 Data Source: Company, Equitymaster Research

Generating more sales on less assets means tying up of less capital that a business generates on its assets. As such, determining the asset management capability of a company is the key to gauging the quality of its RoE.

RoE and leverage
Leverage (the other name for debt) is a tool finance managers can use to perk up a company's RoE in the short term. They can simply take on more of debt than equity to finance their expansion plans. And wow, what investors see is an improved RoE (since debt is deducted from assets to calculate the value of equity)! However, over the long-term, the fact that the company has to pay interest on this debt, reduces its profit margins. This acts as a counter to the rise in RoE due to increased debt levels (if the debt is not productively employed).

Thus, investors need to study debt levels of a company, as this would make their understanding of RoE even simpler. In this case, since Infosys has no debt on its books, its RoE tracks the leverage. However, in case of companies with high levels of debt (those in capital intensive industries like steel and automobiles), the leverage ratio will play a very important role in understanding the RoE.

It may be noted that TCS's RoE for FY09 stood at 33.5%. While the company has poorer margins as compared to Infosys, the fact that it has a higher leverage ratio (1.44) as compared to Infosys has driven up its RoE.

 Data Source: Company, Equitymaster Research

While RoE is important, it is not everything
RoE suffers from one drawback. As mentioned earlier, a company that takes high levels of debt will show up a high return on equity. As such, 'Return on Invested Capital (RoIC)' and not RoE will be a good indicator of testing the company's efficiency levels. However, for understanding the value of companies with nil or marginal amounts of debt, RoE is of great help. We shall explain this with an example:

Company 'A' is a debt-free company with a networth of Rs 100 m. During FY09 it earned a net profit of Rs 15 m. As such, its RoE would stand at 15% for the year. Now, in another case, company 'B' has a net worth of Rs 50 and a debt to equity ratio of 1:1. This means it would have taken up debt to the tune of Rs 50 m. Capital employed in the business is the same amount as of company 'A' - Rs 100 m.

Now, as the company has taken up some debt, it would have to pay a certain amount of interest on the debt. For instance, the interest rate on the debt is 10% for the year. As such, the interest cost for the company will be Rs 5 m (10% * Rs 50 m) for the year. The net profit for the year will stand at Rs 10 m (Rs 15 m – Rs 5 m). Now, if we calculate RoE on this basis, it would stand at a high rate of 20% (Rs 10 m / Rs 50 m). This does show the wrong picture.

As such, it helps investors to look at trends in RoE over a number of years and analyse each of its components (as mentioned above). It will not only help them understand the P&L account, but also to balance this against the much overlooked left and right sides of the balance sheet.

1 Responses to "One ratio every investor must understand"

K.Bala.

Jul 3, 2015

A well-written article that would help lay-man investors !

## More Views on News

### 6 Popular Stocks that Turned into Penny Stocks(Views On News)

Nov 27, 2021

A look at popular stocks that crashed big time and never recovered, i.e. which went from 'Multibaggers to Multibeggers'.

### ONGC to NMDC: Here are 5 Stocks Value Investors Should Closely Track(Views On News)

Nov 26, 2021

Before investing in value stocks, research the company and gain insight into why the market is discounting it.

### Infosys vs TCS: Which is Better?(Views On News)

Nov 26, 2021

In the post pandemic era, the top two IT companies in India are fighting to capture the growing demand for IT.

### Equitymaster's Top 10 on YouTube. Watch Now(Views On News)

Dec 4, 2021

Here, we look back and share our top 10 videos.

### Watch This Before You Buy NBFC Stocks(Fast Profits Daily)

Dec 3, 2021

My view on NBFC stocks.

More Views on News

## Most Popular

### SWOT Analysis for Stocks

SWOT analysis guide for investors in the Indian share market.

### Infosys vs TCS: Which is Better?(Views On News)

Nov 26, 2021

In the post pandemic era, the top two IT companies in India are fighting to capture the growing demand for IT.

### This Multibagger Stock Zooms 20% After Dolly Khanna Buys Stake(Views On News)

Nov 24, 2021

Shares of this edible oil company zoomed over 50% in three days after ace investor bought around 1% stake.

### 6 Popular Stocks that Turned into Penny Stocks(Views On News)

Nov 27, 2021

A look at popular stocks that crashed big time and never recovered, i.e. which went from 'Multibaggers to Multibeggers'.

### India's Top 5 Monopoly Stocks to Watch Out for(Views On News)

Nov 30, 2021

These 5 companies dominate their sectors with a huge piece of the pie.

More

Become A Smarter Investor
In Just 5 Minutes

Get our special report Multibagger Stocks Guide (2022 Edition) Now!
We will never sell or rent your email id.