What is the Return on Equity?

A look at a couple of the most useful, but rarely quoted parameters for evaluating investments.

First Published in the Economic Times, 23 February, 1997

Like all of us small investors, Ramu fancied his abilities at stock-picking. Of late, having skillfully negotiated the minefields of the post scam period, Ramu was feeling very smug and satisfied. Only to be sent reeling by diving commodity prices, MAT and dubious other income. And then an endless stream of confused industry statistics came pouring in, followed by money supply, inflation and interest rates, most of it in small letters on dirty pink. And just when Ramu was recouping from the information overload, his broker dumped a bucket of P/E ratios down his throat. In a bid to escape the onslaught, he made his way to Smith, Wesson and Smith; where his friend Suresh worked as an analyst - only to be accosted by free, non-operating and discounted cash flows.

Ramu was last seen with bloodshot, watering eyes, running around maniacally on Dalal Street, tearing up every "Bhav Copy" in sight, shouting obscenities at the kerb traders.

The relentless stream of fancy jargon, dressed up figures and meaningless formulae are enough to drive the keenest investor up the wall. Compared to a few years ago, when little was known or written about our companies and industries, today we are inundated with data, analysis and recommendations.

And in the meantime, good old book value is now obsolete, while P/E ratios don't seem to work anymore. So how do we sift through the clutter, or must we succumb to the slick marketing of finance companies, who would like us to believe that we are incapable of evaluating stocks, and should turn over our hard earned savings to tie toting MBAs whose American accents grow stronger by the day.

Though stock-picking is not easy, there is a basic ground rule governing all investments - What is the return? Ask this question and a lot of things will fall in place. And yes, there are fairly straightforward ratios which help us calculate this. Two of the most common are the "Return on Equity" (ROE) and "Return on Capital Employed" (ROCE).

All over the world, return on equity is the final arbiter. Not only investors, but even promoters measure their performance by the returns generated on their funds. But in India, where promoters are more interested in size, sales growth and their own importance, they along with their merchant banker buddies, have tried their best to obfuscate the issue. In doing so, they have been able to fulfill their own grandiose ambitions, without giving fair returns to minority shareholders.

Lest I too am accused of saying a lot while explaining nothing, let us examine the fundamentals. If you bought Rs. 100 worth of Tisco bonds, and earned interest of Rs. 18 per year, then the return on your investment is 18%. If Kotak issued bonds at 19%, it would be immediately clear that this investment would generate better returns. Now apply the same principle to companies.

If company A has a total equity (net worth) of Rs. 100, and its net profit is only Rs. 15, then isn't it better for the owners of the company to liquidate and invest all their money in Tisco bonds? Ultimately, a company must earn more than the cost of money - or else it has no business being in business. Though this seems fairly obvious, how often do we see promoters mentioning ROE in their balance sheets or prospectuses?

The ROE helps us get around the whole problem of par values, another fools notion. A company issuing shares at Rs. 50, justifies this by projecting an EPS of Rs. 6 on a par value of Rs. 10. But in reality, the return on the investment of Rs. 50 is just 12%.

However, net profits (and ROE) can still be jacked up by playing around with taxes or increasing debt. This is where the ROCE comes in. Here the total pre-tax return (profit before tax plus interest) is measured against the total capital employed (equity plus debt). Once again, if the ROCE is lower than the cost of money (pretax), the company has no reason to exist.

Most investors are happy when companies go in for debt financing, since this reduces chances of equity dilution. However, the cost of debt is critical. If a company borrows at 18% and earns a ROCE of 15%, then it is actually losing money, even though tax shields on new investments may boost ROE and net profit in the short run. Look closely at some of the so-called blue chips that had debt issues last year. I am sure the results will shock you.

Before somebody gets on my case about the Indian markets being immature and all this is only relevant in the West, etc., etc., lets look at some hard statistics. Between 1991 and 1996, the 100 best performing stocks all have two things in common. All of them appreciated in value at over 30% per annum compounded, and all of them had ROEs and ROCEs in excess of 20%. Consider multinational companies, the tried and tested performers. On an average they have an ROCE over 20% and ROE of around 18%. In comparison, the average Indian company returns only around 13% on equity and total capital. Check it out yourself. Look at some of the exceptions like Gujarat Ambuja, Infosys, TVS Suzuki, etc.

In evaluating the returns generated by companies, consistency is vital. The company must be able to maintain, if not improve its rates of return. Often a sudden increase in equity or debt can throw the numbers off balance. Hence it is preferable to use the average equity (or capital) employed by adding the year-end and year-beginning equity and dividing it by two for computing the ROE. Many other refinements are possible - some prefer measuring cash returns, others like to exclude dividend payouts. For secondary market investments, one could also look at the return on market value of equity (as against book value), or at return on total invested capital (debt plus market capitalisation).

However, regardless of how the returns are computed, the idea is the same. A company must consistently earn more than its cost of capital. Use this criteria for filtering out unsuitable investments, and once these conditions are satisfied - then worry about industry scenario, growth, P/Es and other fancy stuff.