A brief discussion on interpretation and limitations of 'Return on Equity'

Return on Equity is one ratio that is favoured by investors and also bears much importance. At times, companies tend to amplify the ratio. Have a look at how can this happen!

To begin with the basics, let us quickly go through what is ROE?

ROE measures the profitability of a company and displays how much money a company generates on the shareholder's funds.

A simple formula that leads us to the calculation of ROE is :

Return on Equity (ROE) = Net Income/Shareholder’s equity.

It seems easy to calculate it right?

The only thing to be done is to take the net income figure present on the P&L statement and divide the same with the shareholders' equity figure displayed on the balance sheet. 

However, this simple metric has several flaws that keep it from being useful. Let's have a look at the same -

1. Share buybacks: ROE can be manipulated easily. To increase the ROE, either one can increase the numerator, that is the net income or decrease the denominator i.e shareholder's equity. Now an apt way is to boost the net income by efficiently managing the operations and reducing costs, but some companies turn to the second technique of reducing the shareholder's equity. Shareholder's equity can be lowered by a share buyback scheme, where a company buyback its shares using its retained earnings or profits. Through this technique, a company zooms its ability to turn its equity investments into profits.
2. High leverage: Another limitation of "ROE" is the equity part in it, as this formula only conveys the returns on the shareholder's equity and sidetracks the debt component in the capital structure. Generally, for a company to increase its ROE, it has to increase net income, to increase the income a company would require additional investments, and a company can get additional investments either through debt or equity. When a company acquires capital through equity, it contracts the ROE. So, some companies opt to raise the capital through debt, which would boost the profits and improve the ROE, as it only takes into account shareholders' equity. During an economic downturn, higher debt in the capital is risky as the company is likely to default on interest payments. So, the companies relying highly on debt are inclined to have a higher ROE.
3. Net Earnings: Net earnings of a company are likely to be easily manipulated by the management of the company. This is because different companies make use of different methods to calculate figures of net earnings.

So now the question pops up, 

How to interpret ROE? 

The DuPont analysis is a framework for analyzing fundamental performance popularized by the DuPont Corporation. DuPont analysis is a useful technique used to decompose the different drivers of return on equity (ROE). The decomposition of ROE allows investors to focus on the key metrics of financial performance individually to identify strengths and weaknesses. 

If we break down the formula of return on equity, we get

ROE= Net Profit Margin x Total Asset Turnover Ratio x Financial Leverage

Net Profit Margin tells us how well the company is managing its costs. Higher NPM would mean more earnings for the cost per unit of sales and a higher ROE.

The asset turnover ratio tells us how efficiently the company uses its assets to generate revenue - High asset turnover ratio means the company is deploying its assets efficiently.

Financial leverage is the extent to which the company uses debt to finance its operations.

Ideally, a firm is expected to have a High Net Profit Margin, a High Asset Turnover Ratio and should use Less Leverage to generate high ROE.