Return on Equity Meaning
Return on Equity is a profitability metric that is used to compare the profits earned by a business to the value of its shareholders’ equity. ROE is calculated as Net Income divided by Shareholders Equity and is presented as a percentage. A 15% ROE indicates that the corporation earns $15 on every $100 of its share capital.
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For eg:
Source: Return on Equity (ROE) (wallstreetmojo.com)
ROE Formula
The formula of Return on Equity is stated below –
Return on Equity Formula = Net Income / Total Equity
Consider the following example of 2 companies having the same net income but different components of shareholder’s equity.
| Particulars | Company A | Company B |
|---|---|---|
| Net Income | $5,000 | $5,000 |
| Shareholder’s Equity | $20,000 | $12,000 |
The ROE arrived after applying the formula are given as under
If one were to notice, we can see that the net income earned by the companies are the same. However, they differ with regard to the equity component.
Hence by looking at the example, we can understand that a higher ROE is always preferred as it indicates efficiency from the side of the management in generating higher profits from the given amount of capital.
Interpretation of Return on Equity
You can interpret ROE by expanding the ROE formula and make use of Dupont ROE equation.
DuPont ROE = (Net Income / Net Sales) x ( Net Sales / Total Assets) x Total Assets / Total Equity
DuPont Return on Equity = Profit Margin * Total Asset Turnover * Equity Multiplier
Now you can interpret that they all are separate ratios. If you are wondering how come we have come to the conclusion that if we multiply these three ratios, we will get a return on equity, here’s how we have reached a conclusion.
- Profit Margin = Net Income / Net Sales
- Total Asset Turnover = Net Sales / Average Total Assets (or Total Assets)
- Equity Multiplier = Total Assets / Total Equity
ROE is always useful. But to those investors who want to find out the “why” behind the current ROE (high or low), they need to use DuPont analysis to pinpoint where is the actual problem lies and where the firm has done well in.
In the DuPont model, we can look at three separate ratios by comparing which they can come to a conclusion whether it’s wise for them to invest in the company or not.
For example, if in equity multiplier, if we find out that the firm is more dependent on the debt rather than equity, we may not invest in the company because that may become a risky investment.
On the other hand, by using this DuPont model, you would be able to pare down the chances of losses by looking at profit margin and asset turnover and vice versa.
ROE Example
In this section, we will take two examples of Return on Equity. The first example is the easier one, and the second example would be a bit complex.
Let’s jump in and see the examples right away.
Example # 1
Let’s look at two firms A and B. Both of these companies operate in the same apparel industry, and most astonishingly, both of their Return on Equity (ROE) is 45%. Let’s look at the following ratios of each company so that we can understand where the problem lies (or opportunity) –
| Ratio | Firm A | Firm B |
|---|---|---|
| Profit Margin | 40% | 20% |
| Total Asset Turnover | 0.30 | 5.00 |
| Equity Multiplier | 5.00 | 0.60 |
Now let’s look at each of the firms and analyze.
For Firm A, the profit margin is great, i.e., 40%, and financial leverage is also quite good, i.e., 4.00. But if we look at the total asset turnover, it’s much less. That means Firm A is not able to utilize its assets properly. But still, due to the other two factors, the Return on Equity is higher (0.40 * 0.30 * 5.00 = 0.60).
For Firm B, the profit margin is much lower, i.e., just 20% and the financial leverage is very poor, i.e., 0.60. But the total asset turnover is 5.00. Thus, for higher asset turnover, Firm B has performed well in the overall sense of Return on Equity (0.20 * 5.00 * 0.60 = 0.60).
Now imagine what would happen if the investors would only look at the Return on Equity of both these firms, they would only see that the ROE is quite good for both of the firms. But after doing DuPont analysis, the investors would get the actual picture of both of these firms.
Example # 2
At the of the year, we have these details about two companies –
| In US $ | Company X | Company Y |
|---|---|---|
| Net Income | 15,000 | 20,000 |
| Net Sales | 120,000 | 140,000 |
| Total Assets | 100,000 | 150,000 |
| Total Equity | 50,000 | 50,000 |
Now, if we directly calculate the ROE from the above information, we would get –
| In US $ | Company X | Company Y |
|---|---|---|
| Net Income (1) | 15,000 | 20,000 |
| Total Equity (2) | 50,000 | 50,000 |
| Return on Equity (1 / 2) | 0.30 | 0.40 |
Now using the DuPont Analysis, we would look at each of the components (three ratios) and find out the real picture of both of these companies.
Let’s calculate the profit margin first.
| In US $ | Company X | Company Y |
|---|---|---|
| Net Income (3) | 15,000 | 20,000 |
| Net Sales (4) | 120,000 | 140,000 |
| Profit Margin (3 / 4) | 0.125 | 0.143 |
Now, let’s look at total asset turnover.
| In US $ | Company X | Company Y |
|---|---|---|
| Net Sales (5) | 120,000 | 140,000 |
| Total Assets (6) | 100,000 | 150,000 |
| Total Asset Turnover (5 / 6) | 1.20 | 0.93 |
We will now calculate the last ratio, i.e., the financial leverage of both the companies.
| In US $ | Company X | Company Y |
|---|---|---|
| Total Assets (7) | 100,000 | 150,000 |
| Total Equity (8) | 50,000 | 50,000 |
| Financial Leverage (7 / 8) | 2.00 | 3.00 |
Using DuPont analysis, here’s the ROE for both of the companies.
| In US $ | Company X | Company Y |
|---|---|---|
| Profit Margin (A) | 0.125 | 0.143 |
| Total Asset Turnover (B) | 1.20 | 0.93 |
| Financial Leverage (C) | 2.00 | 3.00 |
| Return on Equity (DuPont) (A*B*C) | 0.30 | 0.40 |
If we compare each of the ratios, we would be able to see the clear picture of each of the companies. For Company X and Company Y, financial leverage is the strongest point. For both of them, they have a higher ratio in financial leverage. In the case of profit margin, both of these companies have a lesser profit margin, even less than 15%. The asset turnover of Company X is much better than Company Y. So when investors would use DuPont, they would be able to understand the pressing points of the company before investing.
Calculate Return on Equity of Nestle
Let’s look at the income statement and balance sheet of Nestle, and then we will calculate the ROE and ROE using DuPont.
Consolidated income statement for the year ended 31st December 2014 & 2015
The consolidated balance sheet as at 31st December 2014 & 2015
Source: Nestle.com
- ROE Formula = Net Income / Sales
- Return on Equity (2015) = 9467 / 63986 = 14.8%
- Return on Equity (2014) = 14904 / 71,884 = 20.7%
Now we would use DuPont analysis to calculate Return on Equity for 2014 and 2015.
| In millions of CHF | 2015 | 2014 |
|---|---|---|
| Profit for the year (1) | 9467 | 14904 |
| Sales (2) | 88785 | 91612 |
| Total assets (3) | 123992 | 133450 |
| Total Equity (4) | 63986 | 71884 |
| Profit Margin (A = 1/2) | 10.7% | 16.3% |
| Total Asset Turnover (B = 2/3) | 0.716x | 0.686x |
| Equity Multiplier (C = 3/4) | 1.938x | 1.856x |
| Return on Equity (A*B*C) | 14.8% | 20.7% |
As we note from above, that basic ROE formula and DuPont FormulaDuPont FormulaDuPont formula determines the return on equity (ROE), depicting the efficient utilization of shareholders' capital into the business for generating revenue. The formula is "Return on Equity (ROE) = Profit Margin * Total Asset Turnover * Leverage Factor".read more provides us with the same answer. However, DuPont analysis helps us in analyzing the reasons why there was an increase or decrease in ROE.
For example, for Nestle, Return on Equity decreased from 20.7% in 2014 to 14.8% in 2015. Why?
DuPont Analysis helps us find out the reasons.
We note that Nestle’s Profit Margin for 2014 was 16.3%; however, it was 10.7% in 2015. We note that this is a huge dip in profit margin.
Comparatively, if we look at other components of DuPont, we do not see such substantial differences.
- Asset Turnover was 0.716x in 2015 as compared to 0.686x in 2014
- Equity MultiplierEquity MultiplierThe equity multiplier is a simple ratio of total assets to total equity that helps us understand how much of the company's assets are financed by shareholder equity. If this ratio is higher, the financial leverage (total debt to equity) is higher and vice versa.read more was at 1.938x in 20.15 as compared to 1.856x in 2014.
There we conclude that the decrease in profit margin has led to the reduction of ROE for Nestle.
Colgate’s ROE calculation
Now that we know how to calculate Return on Equity from Annual Filings let us analyze the ROE of Colgate and identify reasons for its increase/decrease.
Below is a snapshot of the Colgate Ratio Analysis Excel Sheet. You can download this sheet from Ratio Analysis TutorialRatio Analysis TutorialRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements.read more. Please note that in Colgate’s calculation of ROE, we have used Average Balance Sheet numbers (instead of year-end).
Colgate Return on Equity has remained healthy in the last 7-8 years. Between 2008 to 2013, ROE was around 90% on average.
In 2014, Return on Equity was at 126.4%, and in 2015, it jumped significantly to 327.2%.
This has happened despite a 34% decrease in Net Income in 2015. Return on Equity jumped significantly because of the decrease in Shareholder’s
Equity in 2015. Shareholder’s equity decreased due to share buybackShare BuybackShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company.read more and also because of accumulated losses that flow through the Shareholder’s Equity.
Colgate Dupont Return on Equity = (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Shareholder’s Equity). Here please note that the Net Income is after the minority shareholder’s payment. Also, the shareholder’s equity consists of only the common shareholders of Colgate.
We note that the asset turnover has shown a declining trend over the past 7-8 years. Profitability has also declined over the past 5-6 years.
However, ROE has not shown a declining trend. It is increasing overall. This is because of the Equity Multiplier (total assets / total equity). We note that the Equity Multiplier has shown a steady increase over the past 5 years and is currently stands at 30x.
Limitations of ROE
- There are so many inputs to be fed. So if there is one error in the calculation, the whole thing would go wrong. Moreover, the source of information also needs to be reliable. The wrong calculation means a wrong interpretation.
- Seasonal factors should also be taken into consideration in terms of calculating the ratios. In the case of DuPont Analysis, the seasonal factors should be taken into account, which most of the time isn’t possible.
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