What is ROE?
Return on equity = net profit ÷ shareholders’ equity. Net profit comes from the bottom line of the income statement, and equity from the balance sheet: all assets minus all liabilities. When equity differs between the start and end of the year, many people use the average of the two.
Put simply, ROE says how many taka of profit the company makes in a year for every Tk 100 of its owners’ money. An ROE of 15% means Tk 15 of profit a year for every Tk 100. Some of that profit is paid out as dividends; the rest stays in the business and adds to equity.
Say Mitu and Zaman each start a business with Tk 2 lakh of their own money. Mitu’s tiffin service makes Tk 40,000 net profit a year, an ROE of 20%. Zaman’s clothes shop makes Tk 20,000, an ROE of 10%. With the same money in, Mitu’s business earns twice as much. The numbers are only an example.
Why it matters to an investor
- To see how well management uses the owners’ money: a good ROE year after year is usually a sign of a strong business.
- To get a sense of future growth: a company that can keep its profits in the business at a high ROE can grow its equity and profits faster.
- To compare with alternatives: if a company’s ROE stays below what low-risk deposits pay for years, that is worth thinking about.
- To make sense of P/B: the market usually pays more relative to book value for companies with a higher ROE.
DuPont: splitting ROE into three parts
The same ROE can come from three very different routes. The DuPont method shows ROE as the product of three parts: ROE = net profit margin × asset turnover × leverage. That is: how much profit each Tk 100 of sales brings, how much is sold for each taka of assets, and how much of the assets is paid for by owners’ money versus borrowed money.
- Net profit margin = net profit ÷ sales. Usually higher for premium brands or specialised products.
- Asset turnover = sales ÷ total assets. Usually higher in low-margin, high-volume businesses such as retail or trading.
- Leverage = total assets ÷ equity. The more debt, the higher this is, and the bigger ROE looks.
When a high ROE misleads
- Heavy debt: small equity and large debt make ROE look high, but the risk rises too. In a bad year the same debt magnifies the loss.
- One-off gains: a profit from selling land or a subsidiary can swell one year’s earnings in a way that won’t repeat.
- Tiny or negative equity: when past losses have nearly wiped out equity, even a small profit gives a huge ROE; if equity is negative, ROE stops meaning anything.
- A single year: not one good year, but five to ten years of ROE shows the real character of the business.
Worked example
- Say a made-up company, “Rupsha Foods Ltd”, has sales of Tk 300 crore and net profit of Tk 30 crore for the year. Equity was Tk 190 crore at the start and Tk 210 crore at the end; the average is Tk 200 crore.
- ROE = 30 ÷ 200 = 15%.
- If average total assets are Tk 500 crore: margin = 30 ÷ 300 = 10%, turnover = 300 ÷ 500 = 0.6, leverage = 500 ÷ 200 = 2.5.
- Check: 10% × 0.6 × 2.5 = 15%.
Result: much of the 15% ROE comes from leverage. If all the assets had been paid for with owners’ money (leverage of 1), the same business would earn an ROE of about 6%. So look not just at ROE but at the route it comes by. The numbers are only an example.
Common mistakes
- Looking only at the ROE figure and not at the part debt plays.
- Deciding on one year’s ROE rather than the trend over several years.
- Treating a huge ROE on negative or tiny equity as success.
- Comparing ROE directly across industries; what is normal differs by type of business.
ROE tells you how much profit a company makes on each Tk 100 of its owners’ money; look at the trend over several years, and use DuPont to check whether it comes from margins, sales or debt.