Chapter 2: Ratio Analysis

Lecture 2.8: Return on Equity

 Indicates the return obtained by shareholders for each unit of investment made in the company

Return on Equity Comprehensive Result

=
(ROE) Common Shareholder’s Equity
 It should be as high as possible:
A higher value means the company will be providing its investors with a higher return. This, in turn, will make it
easier for the firm to raise capital whenever needed, thus ensuring it will have an easier time meeting its obligations
than firms that ensure low returns to its potential shareholders.

 This is the most sought after measure by potential equity investors, as it will allow them to make quick
comparisons between the return yielded by the company and that they could obtain in other investment
opportunities

 This measure is also typically used to break down the company’s activity and provide a holistic view of
sources of return for the shareholder.
Level 1 Decomposition
𝐶𝑜𝑚𝑝𝑟𝑒ℎ𝑒𝑛𝑠𝑖𝑣𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑒𝑠𝑢𝑙𝑡 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑅𝑒𝑠𝑢𝑙𝑡
𝑅𝑂𝐸 = = +
𝐸𝑞𝑢𝑖𝑡𝑦 𝐸𝑞𝑢𝑖𝑡𝑦 𝐸𝑞𝑢𝑖𝑡𝑦

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑒𝑠𝑢𝑙𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑅𝑒𝑠𝑢𝑙𝑡 𝑁𝑒𝑡 𝐷𝑒𝑏𝑡

= × + ×
𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝑁𝑒𝑡 𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦

𝑰𝑪 𝑫
= 𝑹𝑶𝑰𝑪 × − 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑬𝒙𝒕𝒆𝒓𝒏𝒂𝒍 𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒏𝒈 ×
𝑬 𝑬

Return on Equity is the weighted average of the return from operations and the negative return (cost)
from financing activities
 Level 2 Decomposition
𝐼𝐶 𝐷
𝑅𝑂𝐸 = 𝑅𝑂𝐼𝐶 × − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 ×
𝐸 𝐸

𝐷+𝑬 𝑫
= 𝑅𝑂𝐼𝐶 × − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 ×
𝑬 𝑬

𝐷 𝑫
= 𝑅𝑂𝐼𝐶 × 1 + − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 ×
𝐸 𝑬

𝐷 𝑫
= 𝑅𝑂𝐼𝐶 + 𝑅𝑂𝐼𝐶 × − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 ×
𝐸 𝑬

𝑫
= 𝑹𝑶𝑰𝑪 + × (𝑹𝑶𝑰𝑪 − 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑬𝒙𝒕𝒆𝒓𝒏𝒂𝒍 𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒏𝒈)
𝑬

Return on Equity increases with the return from invested capital and with the excess return made on the amount
of capital that is externally raised
 Level 3 Decomposition
𝑅𝑂𝐸 = 𝑅𝑂𝐼𝐶 + 𝐷/𝐸 × (𝑅𝑂𝐼𝐶 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔)

= 𝑊𝐶𝑜𝑟𝑒 × 𝑅𝑂𝐼𝐶𝐶𝑜𝑟𝑒 + 𝑊𝑁𝑜𝑛 𝐶𝑜𝑟𝑒 × 𝑅𝑂𝐼𝐶𝑁𝑜𝑛 𝐶𝑜𝑟𝑒 + 𝐷/𝐸 × (𝑅𝑂𝐼𝐶 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔)

= 𝑊𝐶𝑜𝑟𝑒 × 𝐶𝑜𝑟𝑒 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝐶𝑜𝑟𝑒 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 + 𝑊𝑁𝑜𝑛 𝐶𝑜𝑟𝑒 × 𝑅𝑂𝐼𝐶𝑁𝑜𝑛 𝐶𝑜𝑟𝑒 + 𝐷/𝐸 × (𝑅𝑂𝐼𝐶 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔)

CORE ACTIVITY NON CORE ACTIVITY FINANCING ACTIVITY

Increases with Core ROIC which itself depends on Increases with Non Increases with excess return made on the
operational margin and asset turnover Core ROIC amount of capital that is externally raised
Sales 1 051 569 143
Operating Result 457 139 48
Invested Capital 1 265 401 68
Operating Margin 43% 24% 33%
Asset Turnover 83% 142% 210%
ROIC 36% 35% 70%
Weight 73% 23% 4%
Weighted ROIC 26% 8% 3%
= 𝑊𝐶𝑜𝑟𝑒 × 𝐶𝑜𝑟𝑒 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝐶𝑜𝑟𝑒 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 + 𝑊𝑁𝑜𝑛 𝐶𝑜𝑟𝑒 × 𝑅𝑂𝐼𝐶𝑁𝑜𝑛 𝐶𝑜𝑟𝑒 + 𝐷/𝐸 × (𝑅𝑂𝐼𝐶 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔)

CORE ACTIVITY NON CORE ACTIVITY FINANCING ACTIVITY

315% X 37% = 117% -215% X 16% = -35% -143% X (82%-4%)=-112%

117%-35%=82% -112%

-30%