Monday 11 June 2012

Dissecting Return on Equity: Few Insights from Britannia and Titan

As mentioned in earlier post on significance of return on equity, ROE is one of the most important parameters signifying sustainable competitive advantage of the business and hence investment attractiveness of the company. However, as I dug deeper and gained more insight into the subject, I found that relying just on ROE number may be misleading. It is very important to understand what drives change in ROE and how good is the quality of ROE. In this post, I will try to illustrate the point with two examples. What is common in both the examples is that if one looks at ROE of the company, it has moved in a band has remained in that band. However, in one case, business quality has deteriorated while in the other, business is clearly on the upswing. However, had one relied on just ROE number, one would not be able to get a realistic feel of changing business environment. 

Let me start with defining ROE in terms of equation as suggested in Dupont formula 

ROE = Net profit margin *  Asset Turnover ratio * Equity Multiplier 

So ROE = (Net Profit/Total Revenue) * (Total Revenue/Total Assets) 
              * (Total Assets/Total Equity) 

So now, it is clear that three parameters drive return on equity, we can dissect ROE of any company in three components and look at what is driving ROE. This dissection of ROE will help us gain insight which can reveal interesting information about changing business environment for the company. 

Let's take first an example of Britania Industries.

Britannia Industries: Britannia Industries is India's leading food products company having formidable brands such as Good Day, BourBon, Little Hearts,  Marie Gold and Treat in biscuit segment and strong brands in dairy products such as Cheese, Butter, Spread and Yogurt. Let's see what has happened to ROE of the company. 


So on the first glance it appears that Britannia has increased its earning on its equity hence each dollar put in as equity by the company is earning 41 cents in 2010-11, up from 18 cents in 2006-07. Typically this would suggest that company's business is getting stronger and "moat" around its business is growing. However, let me dissect ROE further into its three core components.

            2006-07 2007-08 2008-09 2009-10 2010-11
    Profit/Revenue (1)   
    Revenue/Assets (2)   
3.24 2.91 3.55 4.12 4.98
    Asset/Equity (3)  
    Return on Equity (1*2*3)   

Above analysis, indicates that for Britannia, NPM has been fluctuating and has declined substantially in 2009-10 and 2010-11 from 4% to 2.6-2.8% which indicates deteriorating business conditions. On the other hand, company's  Asset/equity ratio has increased substantially from 1.33 to 2.9 indicating substantial increase in debt/equity ratio and hence leveraging. Thus increase in ROE for the company seems to have been contributed to a large extent by leverage and higher asset turnover to a smaller extent. Thus, it is reasonable to infer that in spite of increased return on equity, Britannia's inherent business condition is worse than that of 2006-07. 

Titan Industries: Titan is India's largest watch maker and world's fifth largest watch maker. Titan is perceived as benchmark of quality blended with style in Indian watch industry. Titan has also created immensely popular brands such as Fast-track and Raga catering to youth and effluent class respectively. Titan has entered into branded jewelry segment with "Tanishq" brand, which proved to be an run-away success. It also started "Titan Eye" division catering to style conscious youth by creating a range of stylish eye wear. Let's understand how Titan's business has undergone change and why "wholesome" ROE may not adequately reflect changes in business environment but dissecting ROE into its base components will give a insight into how business fundamentals are changing. 


If we look at ROE for last 5 years for Titan, it appears that Titan is operating in a business environment which is stable till 2009-10 (except in 2008-09) and ROE has remained in the range of 30-34% barring 2010-11 when ROE jumped substantially. This gives an impression that Titan operates in a business environment that is neither improving nor deteriorating substantially. Now let's see how drivers of ROE has changed over a period of time. 

            2006-07 2007-08 2008-09 2009-10 2010-11
    Profit/Revenue (1)    
    Revenue/Assets (2) 
4.17 5.22 5.71 6.13 6.6
    Asset/Equity  (3)  
    Return on Equity (1*2*3)   

Above table clearly indicates that Titan's ROE is incrementally contributed from expanding margins and higher asset turnover. A combination of margin expansion and higher revenue generation/rupee of asset on the book is helping Titan improve its return on equity. However in terms of overall ROE number, this effect is muted as company is consistently reducing debt (reducing leverage) which offsets the effect of increase in margin and asset turnover on ROE number. Expanding margin and increasing utilization of asset for revenue generation and that too consistently, indicates company's improved  business fundamentals which one would fail to notice if the focus is on just "ROE" number. On the other hand company has reduced its debt substantially over a period of time, which has strengthened its balance sheet

To put it differently, had Titan maintained debt/equity at a level prevailing in 2006-07, company's ROE would have looked liked as below


Thus, even though Titan's business environment and fundamentals have changed significantly they are so "jumbled up" that overall ROE number would not help investor decipher such changes. 

It is therefore critical to dig deeper into ROE number and understand drivers of ROE which will truly reflect the changing business environment and contributory effect of each component of ROE. 


  1. Hi Dhwanil,

    That's a fantastic post. I am having some doubt on what's to be taken as Total Asset in the calculation.
    Referring to the page 32 of 2010-11 AR of Britannia. Can you tell me which figure you picked as the total assets ?


    1. Hi Raja,

      I think Page 32 indicates standalone balance sheet which is not accurate. Consolidated numbers for the company are indicated on page 76. As described on Page 76, Total Assets will include, net fixed assets, net working capital and investment. It will be equivalent to total liabilities. In this case Total Assets for 2010-11 is 953 crores on equity base of 326 crores.

  2. Dear Dhwanil,

    One of the best blogs on Value investing and i request you to keep posting on a regular basis.

    I came across your blog while I was surfing as usual for Value investing and ended up reading your entire blog at one go.

    Can you suggest some good material to improve the investing skills.

    Keep posting !


  3. Hi Abhishek,

    Thanks for the compliments. I consider myself relatively new in this field and there are many experienced value investors sharing their ideas through blogs. I think following such blogs will helped me in refining my thought process. Some of them are listed as value investing readings on right hand sidebar on my blog. In addition to this I read books written by all great value investors such as Philip Fisher, Peter Lynch, Mohnish Pabrai, Warren Buffet's letters to shareholders,Charlie Munger's musings on mental models and Prof Sanjay Bakshi's lecture notes posted on his website. This helped me in grounding my ideas into some well developed principles.

    Best Regards
    Dhwanil Desai

  4. Dhwanil

    I hold Britannia with a profit of 42%. I had bought this without thinking much as it was undervalued at that time.Now in dilemma to sell or hold on..after reading this i think i should sell it.i don't want to loose on the 42% profit i am holding now.

    1. Hi Anon,

      Let me point out here that my analysis of Britannia was strictly related to drivers of ROE and in that sense very very limited. I think you should analyze business conditions and valuations before taking a call on selling or holding on.

  5. Superb! Although I had studied about this concept, I had never implemented it in stock analysis. Thanks for bringing it up.

    I would be glad if you could do a post on Exide Industries vs. Amara Raja Batteries. In my view these are excellent companies with distinct strengths of their own (market share vs. low price products) and they are also into a good business with a promising future.

    FYI: The ROE analysis of Amara Raja Batteries shows trends similar to Titan's.

    Kudos to you for this blog!

    1. Hi Anon,

      I entirely agree with you on Exide and Amara Raja Batteries. Both these businesses are wonderful businesses and are run by competent and ethical management (a tough find for Indian corporates). What I like about battery business is
      - Simple business
      - Continuously expanding demand for the product. This is a classic case of exponential growth as increase in automobile sales and resultant replacement demand for batteries every 2-3 years is going to lead to exponential growth.
      - Operates in duopoly (no other significant player in organized battery segment)
      - High asset turnover, good margins and free cashflow means companies need not leverage.

      So in all, a business one would definitely like to own. However currently, Amara Raja is much better investment pick due to valuation gap that exist between Amara Raja and Exide. However, if there is steep correction in the market and exide prices fall significantly, one should buy both Exide and Amara Raja in some proportion and in that way one shall be able to own battery industry in India.

      I hope this helps.