Can you please explain:

ROAE (Return on Average Equity)


ramkasi

i dont really use ROAE but ROE instead. but i believe both are similar except that one uses an average of equity.

ROE = net profit(whole year) / total equity

the above ROE will be annualised. total equity can be taken from the company's balance sheet. its also the net asset or total assets - total liabilities.

MoneyLife has an article on some well-known, evergreen stocks with focus on their ROE.
It also lists some more companies and talks about the plight of Hindustan Unilever - high ROE, but low earnings growth.

I would like some help here ....

I would like to know what are the recommended purchase prices implied by the current figures. Except if another major disaster strikes, are these prices foreseeable?

In my opinion RoE should always be used along with the debt to equity ratio.

By taking on high levels of debt, equity can be maintained at a lower level thus giving a high RoE. However interest payments will be higher and growth in Net Profit (or EPS) will be lower than that suggested by the RoE.

Low RoE and High Debt/Equity ---> May be cause for worry
High RoE and High Debt/Equity ---> Be cautious. More insight is required in to the company's business
High RoE and Low Debt/Equity ---> May be candidate for investing

To add to my post above ...

Tough in general it may appear that having high debt is a problem, it is not ALWAYS so. It depends on the industry and the stage of the company.

Suppose we are starting a company in a very niche field that is expected to have a high RoE and generate strong cash flows, then to begin with it may in fact be better to have a high Debt to Equity Ratio.

In the starting phase, retained earnings are nil (or very low) and most of the equity of formed by the initial capital. If we start of with a high equity (= larger number of shares issues), then this will remain with this for a long time. As the number of shares is the denominator in calculating EPS, this lowers the EPS.

If instead we start of with higher debt, the strong RoE and Cash flows means that the debt can be repaid quickly. For the initial years the EPS will be lower as interest payments will take a toll on the earning. However once the debt if paid off, the benefits of lower number of shares will kick in and EPS will shoot up.

So a company with a potential for High RoE and High actual Debt/Equity can transform itself into a High RoE and low Debt/Equity.

Therefore never go blindly with financial Ratios.

In the limited context of the MoneyLife article, the companies discussed do not have significant D/E ratios.

Nestle, Castrol, Hero Honda, Colgate Palmolive, and GSK all have D/E less than 0.02 according to Rediff Money.

So let's keep high D/E companies out for this purpose ....

Just to look at one example, GSK Pharma (debt-free):

HDFC Sec has reviewed the CY '09 performance here.

From a reading of that note, net sales was Rs. 19 bn and the mcap was Rs. 133.7 bn. So this should give a ratio of mcap to sales of 133.7/19 = 7.03.

And the MoneyLife article I mentioned earlier had this:
"The best time to buy this stock is when it gets valued at 4.2 times sales and 11 times operating profit."

In other words, based on the mcap to sales ratio, the price to buy is ~40% lower than CMP, according to MoneyLife. Is that correct?

Hoping for guidance on this !!!!

Yes.

GSK's CY 2009 standalone sales were around 1660 crore.

4.2 times 1660 = 6972 crore.

Current market value of GSK Pharmaceuticals is 13384 crore.

The recommended price isn't going to come for a long time.

What is useless tip.....

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A high ROE company isn't always a good investment.

GSK Pharmaceuticals may have a high ROE, but it's unable to grow.

That is one primary reason why it distributes half of its PAT as dividends.

Remember that ROE is the return that the company generates on its own equity. ROE is not the return that an investor will get on his investment.

e.g.

Company ABC has an equity of 100 crore and ROE of 50%.

Every year it has a PAT of 50 crore. The company is in a sector where there is no growth and thus it distributes all profits as dividends. The share price doesn't go anywhere because the company's profits aren't increasing.

The shareholders get 42.5 crore as dividends every year.

If someone buys out the whole company for Rs 1000 crore, what returns he will get?

4.25%.....that's it.

Every year, the investor will get 42.5 crore and nothing more.

This company may have a 50% ROE, but for the investor, the ROI would be a mere 4.25%.

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Thanks for answering my basic question. I too feel that the prices suggested to buy at are very often unattainable (except in crisis times).

While it is possible that such prices maybe reached, it is more than likely that they won't!

So a new entrant to the market with cash to deploy will not benefit from such "advice".

I chose GSK Pharma as an example from the list because there was the HDFC Securities article freshly available.

But some of the other companies mentioned do have a high RoE, zero or very low D/E, and have been growing at a good pace.

To be fair, the authors have given the example of HUL (at the end), which is exactly what you have described: high RoE, no growth, and generous pay-outs.

For a business, "return on equity" is a function of leverage and not the other way round.

If a business can generate a "return on assets" that is higher than the cost of debt, it can achieve an infinite ROE.

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Suppose a company has an equity of Rs 1 and debt of Rs 999.

The interest cost per year is Rs 100. The assets created by this company, generate a return of 20% per year, which is Rs 200 per year.

What will be the ROE of the company in first year?

Assuming 30% tax, 5% depreciation and deducting Rs 100 interest, the PAT would be

[(200 -100) - 50] X 0.7 = 35.

An equity of Rs 1 is generating Rs 35 of profit.

An ROE of 3500%.

By using excessive leverage, any company can generate an exceptionally high ROE.

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Leverage is not decided by the future ROE.

It is leverage that decides the future ROE.

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A high debt:equity ratio is not a problem in 2 cases:

1. The "return on assets" for a business is much higher than "cost of debt".

Imagine two companies A and B.

Both having debt:equity ratio of 5:1.

Cost of debt for both is 10%.

A generates 30% returns on its assets and B generates 12% returns in its assets.

Company A has a much higher "margin of safety".

Even if its "return on assets" halves, it would still be able to service its debt.

On the other hand, if B's return on assets falls from 12% to 8%, it may have problems.

8% of 6 = 0.48 which is lower than the interest of 0.5.

2. The "return on assets" is close to (but higher than) the cost of debt and is certain to a large extent.

Indian power companies are a good example - especially the newer ones.

Many of their projects have a cap on returns.

The return on assets that these companies will generate, won't be much higher than their cost of debt.

However, these companies are having a debt:equity ratio of 3:1 or 4:1.

Such high leverage would scare away investors in many sectors, but not in case of power companies.

The reason is that the returns from these projects are certain to a great extent.

Power companies are using high leverage to compensate for the relatively muted "return on assets" in the power sector.

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Another example of this would be the banks and NBFC's..

Both banks and NBFC's get comparatively low returns from their assets.

In India, a loan that the a bank or NBFC gives, generates a return of 9%-14%.

Net interest margins for banks and NBFC's are low and usually are in the 2%-4% range.

These low margins are balanced by high leverage to create an acceptable ROE.

e.g.

This is how HDFC's balance sheet looked at the end of FY2009:



Total debt was 83856 crore and total equity was 13137 crore.

A debt to equity ratio of 6.38.

For other businesses, such a high debt:equity ratio would have meant a warning sign.

However, for bank and finance companies, it's within acceptable limits.

Even tough the returns that their assets generate are low (9%-14%), financial companies(and banks) can afford to leverage aggressively because these returns are secure to a large extent.

A bank that is properly run doesn't usually have much problems with its assets and hardly 2%-4% of the total loans turn bad.

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Of RoE and Croci.

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