## Monday, September 29, 2014

### The 3 components of ROE

I've written in the past about the dangers of relying solely on ROE calculations. The danger comes from not knowing the components that makes up ROE. For the uninitiated, it refers to a matrix called Return on Equities.

 Not this roe lah!

I think it's important to use Dupont analysis of ROE to break up the components of ROE into 3 main categories:

1. Financial leverage = Total assets / Equity
2. Assets turnover = Revenue / Assets
3. Net margin = Profits after tax (PAT)/ Revenues

If you take the 3 ratios above and multiply them, you'll find that the denominator and numerator of most components will cancel each other, giving you :

ROE = Total assets/Equity x Revenue/Assets x PAT/Revenues = PAT/equity

That is the standard formula for the computation of ROE

Let's use some concrete examples. I randomly take 3 STI components, SGX, ST Eng and Capitaland. They have nothing to do with each other (in terms of the business they do). The only commonality is that they have easily accessible annual reports so that I don't have to plow through everything to get the numbers required. Lazy, I know :)

So here it goes:

If you look at the ROE component, you'll have realised that ST Engineering's ROE is high because it is more highly geared up. Basically with leverage, you'll have a multiplier effect on your gains or your losses. That's not necessary bad, it's just that if you compare ROE alone, you'll miss that fact.

Again, if you look at the ROE of SGX, you'll find that the main component driving it is actually it's high net margins. That super delicious net margins pushes up the ROE. That is not necessary good or bad, it's just something that might not be noticed if you just focus on ROE alone.

You can dig more about ROE in my previous post here. The real important one is the 2nd link, but it's riddled with broken links of pictures...argh..

1. Dupont analysis of ROE
2. Woe be to those who missed out ROE
(I apologise for the lack of pictures...the server that I had uploaded the pictures went bust...so it's gone)

Anonymous said...

Hi,

I came across this article and found it to be very helpful, especially to someone who is new to investing like me.

I was wondering, in the balance sheet, sometimes I see "Group" and "Trust" (when I look at REITs and other Trusts).

Which part should I be looking at?
Is there a difference?

A~

la papillion said...

Hi A,

Thanks for reading ;) I hope it helps you in your investing journey :)

Regarding group vs trust, you should look at the group's balance sheet. Usually a trust is held by a group which controls the trust (I think 50% or more stake), so looking at the group is more encompassing and includes all other companies that the group is holding, besides the trust.

This applies to other companies besides reits too. Just always look at the Group part.

I'm not formally trained in accountings, so I might interpret it wrongly. Just google it around, I'm sure you can find some more information regarding this.

You might want to read my newbie's faq here: http://pub11.bravenet.com/faq/show.php?usernum=910991976

Might be able to answer some other queries you might have :)

Anonymous said...

Hi,

Thanks for the clarification and the links, its really helpful to new beginners like myself!

Hope you continue posting more great stuff!

A~

la papillion said...

Hi A,

Most welcomed!