Introduction of ROE
Return on Equity
(ROE) is a term important in shares/equity investment. The simple
formula for ROE is Net Profit / Shareholdings. In short, it is measured
by how strong is the top management to produce profit based on current
shareholdings. In DuPont formula, it is calculated as Net Profit Margin *
Asset Turnover * Equity Multiplier. I will explain to you the
components one by one:Simple DuPont Formula Explanation
- Net Profit Margin (Net Profit / Revenue) - This is one of the very key indicators to measure company performance. A good company with 'Monopoly' status always have a better profit margin as compared to the peer companies. It can be achieved by Economy of Scales or through operation efficiencies. When you notice that the company's profit margin is increasing, perhaps you can check whether it is due to a new product launched or operation efficiencies or due to cost control improvement etc.
- Asset Turnover (Revenue / Asset) - It is an indicator to show whether the company is capable to have a better turnover by selling more products with limited asset available. A low non-current asset based company can perform better than a high non-current asset based company due to its bargaining power against customer.
- Equity Multiplier (Asset / Equity) - Sometimes a good ROE can be due to high equity multiplier. It means that the company has bigger borrowing from bank/payable/bond holders to achieve higher asset. In finance industry, the leverage can be as high as 10 times and above. You must compare the equity multiplier with its peer companies. Normally if company can achieve optimal capital structure, the WACC can be the lowest. Thus, investor can achieve higher returns.
It does not necessary mean that you can achieve a good returns by investing in high ROE company. However, if you can find out a company is having higher and consistent ROE as compared to
its peer company in same sector, it means that this company's management is better to produce better returns as compared to rest. You must also take into considerations the other figures such as Price per Earning ratio, Dividend yield etc.
By comparing ROE with peer companies, you also must take note that whether the company manipulate its annual report. It is also good that you can do a relative comparison on P/E ratio and Dividend Yield while making investment decisions. With a good & consistent ROE, the longer you hold the investment, the better profit you can foresee in long run.
ROE - An Indicator of Company's Organic Growth
An internal growth factor or we call it organic growth factor,
is derived from the formula ROE * RR(retention ratio). For example, if one company achieved 15% ROE, but it gives out all the earned profits to the investors, it will be left zero amount in its shareholders fund and the shareholder fund remains
unchanged. However, if the company retain that 100% profit, the shareholder fund will increased by 15% without taking into account other factors.
In long run, as we know, the long term share price performance is similar to the shareholder fund. So, if shareholder fund increase, the intrinsic value for this company will increase as well.
Howevet, things to take note:
1. A good ROE always shows that there could be some franchise value to the firm. However, we should always remind ourselves that a proper equity multiplier or appropriate corporate finance structure should be found out to achieve optimal intrinsic value to the company.
2. Some instituitional investors would prefer a favorable dividend policy. The more dividend paid out to investor, the less internal growth we can see in the company.
3. Some companies that achieve long term high ROE can be said in a good industry or achieve monopoly situation. However, the companies may issue out the dividends to the investors if there is no good investment opportunities in short run.
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