11 April 2011

ROE - Key Performance Indicator for Company Management

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  
  1. 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. 
  2. 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.
  3. 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.
Things to take note

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.

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