Define Return on equity (ROE) is a financial ratio that measures the amount of net income generated by a company in comparison to the amount of shareholder equity. ROE is calculated by dividing the net income by the average shareholder equity for a given period, usually expressed as a percentage. What Formula? ROE = (Net Income / Average Shareholder Equity) x 100% What Components? A. Net Income The net income used in numerator is Net income attributable to common shareholders or parent and not Net income attributable to Group which includes non-controlling interest Group Net Income for the year = Net income attributable to Common shareholders or Parent + Non-controlling Interest B. Shareholders Equity - Balance sheet Shareholders Equity Attributable to Parent = Shareholders attributable to group – Non-controlling Interest Where Shareholders Equity can be detailed as: Any other type of reserve shall be added. Where can I find them - Financial Statement Linkages? Real Company Analysis Let’s take example of Pidilite Industries Limited, Indian chemical company engaged in producing adhesives, sealants, waterproofing solutions and construction chemicals to arts & crafts, industrial resins, polymers. The annual reports can be found at https://pidilite.com/investors/financials/ How to Interpret? ROE is an important metric for investors as it indicates how effectively a company is generating profits from the equity invested by its shareholders. A high ROE suggests that the company is generating a strong return on investment for its shareholders, while a low ROE may indicate that the company is not generating sufficient profits to justify the investment made by shareholders. However, it's important to note that ROE can be affected by factors such as debt financing and capital structure, so it should be used in conjunction with other financial metrics when evaluating a company's overall financial health. Comparison can be done in the following ways: 1. Temporal Comparison i.e. time series trend analysis 2. Comparison with Industry benchmark 3. Comparison with Industry Average or close peers / competitors Remember when we compare ratios against any average it shall be calculated with same formula otherwise it will result in erroneous comparison. 1. Trend Analysis As can be seen from our example that Pidilite Industries Limited has consistently performing with ROE of above 20% except for 2021 with ROE falling to 19%. 2. Comparison with Industry Average or close Peers: But if we compare it with average (median) ROE of close peers, we find Pidilite Industries Limited has outperformed them by quite a margin as seen from table above. It is important to understand that when we compare ratio with peers/competitors the selection of right peers/competitor is very important. Direct competitors which sell similar if not exactly same type of product or service, in terms of functionality and not form, shall only be compared. What Strategic Implications Firms that have ROCE consistently above Weighted Average Cost of Capital (WACC) have sustainable competitive advantage. If we take the numerator of the ROCE ratio which is EBIT and break it further, we see it dependent on Price, Volume of product sold or frequency of services rendered and cost of service. Firms that can charge premium price or have lower costs will consistently perform better in terms of ROCE compared to WACC. How to Forecast? To forecast ROE we need to forecast Net Income, and Shareholders funds. Shareholders Funds To forecast shareholder’s funds we divided it into its key components: 1. Share Capital 2. Treasury Shares 3. Additional Paid-in Capital 4. Share Premium 5. Reserves 6. Retained Earnings 1. Share capital can be forecasted using straight line method. If you want to get complex, then use additional funding requirement schedule. We need to create and 3-statement model to create such a schedule. We need to assume about what Debt equity ratio to find additional share capital or debt. We can also use the optimal capital structure model to forecast it. 1. Treasury Shares: Treasury Shares are buy-back of shares by firms. To forecast it we can use either straight line method or look at for clues in annual reports Management Discussion & Analysis part where they discuss their plan for buy-back. But it more likely than not firms do not announce it in advance as it influences stock markets. 2. Additional Paid-in Capital: Additional Paid-in capital is additional capital raised by companies. This is similar to share capital we do not need to forecast this and use the share capital schedule. 3. Share Premium: If you have additional capital and assume to place at premium forecast, it using share capital requirement and premium that you will charge per share. Otherwise, use straight line forecast. 4. Reserves Reserves are divided into three types: a. General Reserve: Profits retained in business b. Specific Reserve: Like Debenture Redemption Reserve are type of reserve is maintained for a specific purpose c. Capital Reserves: Reserves created for specific purpose and can be used for that reason only Use straight line method to forecast reserves if details about specific purpose for which reserves were created not available. 5. Retained Earnings

Financial Valuation is both art and science. The science part is the historical data provided by annual reports and art is to estimate of what future holds. There are many different financial valuation methods that businesses and investors use to determine the value of a company or asset. Here are five commonly used methods: A. Discounted Cash Flow (DCF) Analysis: This method involves estimating the future cash flows of a company and then discounting those cash flows back to their present value using a discount rate. The present value of the cash flows is the estimated value of the company. Discounted Cash Flow (DCF) analysis is a method of valuing a company based on the present value of its expected future cash flows. The basic idea behind DCF analysis is that the value of a business is equal to the sum of the present values of all future cash flows expected to be generated by the business. To conduct a DCF analysis, an analyst must first estimate the future cash flows a company is expected to generate. These cash flows are then discounted back to their present value using a discount rate that reflects the time value of money and the risk associated with the investment. The discount rate used in the DCF analysis can be the company's weighted average cost of capital (WACC), which takes into account the cost of debt and equity financing. Alternatively, an analyst may use a higher discount rate to account for the additional risk associated with the investment. The result of the DCF analysis is the estimated intrinsic value of the company, which can be compared to its current market value to determine whether the company is overvalued or undervalued. DCF analysis is widely used in corporate finance and investment banking to evaluate the potential value of an investment or acquisition. B. Comparable Company Analysis (CCA): This method involves comparing a company to other similar companies in the same industry to determine its valuation. This is typically done by looking at metrics such as P/E ratios, revenue growth, and profit margins. Comparable Company Analysis (CCA) is a financial valuation method that compares a company's financial metrics, such as revenue, earnings, or EBITDA, to those of similar companies in the same industry or sector. This method is also known as a "comps analysis" or "peer group analysis." The goal of CCA is to determine the relative valuation of a company by comparing its financial performance to that of similar companies. This allows analysts and investors to assess the company's strengths and weaknesses and identify potential areas for improvement. To conduct a CCA, an analyst typically selects a group of similar companies and compares their financial metrics to those of the company being analyzed. These metrics may include revenue, earnings, profit margins, price-to-earnings ratio (P/E), or price-to-book ratio (P/B). Once the financial metrics of the comparable companies have been collected, the analyst calculates the average or median values for each metric and compares them to the corresponding values for the company being analyzed. If the company being analyzed has higher or lower financial metrics than the comparable companies, it may indicate that the company is overvalued or undervalued relative to its peers. CCA is widely used in investment banking, corporate finance, and equity research to determine the fair value of a company. It's important to note that CCA should not be the only method used to value a company, and analysts should also consider other factors such as the company's growth prospects, industry trends, and macroeconomic conditions. C. Asset-Based Valuation: This method involves valuing a company based on the value of its assets, including tangible assets such as property, plant, and equipment, as well as intangible assets such as intellectual property and brand equity. Asset-Based Valuation (ABV) is a method of determining the value of a company based on its assets and liabilities. This method is particularly useful for companies that have tangible assets, such as manufacturing companies, real estate firms, and mining companies. To conduct an ABV, an analyst begins by determining the value of the company's assets, which may include its land, buildings, equipment, inventory, and investments. The analyst then subtracts the value of the company's liabilities, such as debt, accounts payable, and other obligations. The resulting value is the company's net asset value (NAV). There are two main types of ABV: the going concern asset-based approach and the liquidation asset-based approach. The going concern asset-based approach assumes that the company will continue to operate as a going concern, and therefore, the value of the assets is based on their current market value. The liquidation asset-based approach assumes that the company will be liquidated, and the value of the assets is based on their liquidation value, which is typically lower than their market value. ABV can be used to determine the minimum value of a company in the event of a liquidation or bankruptcy. However, it may not be the most appropriate valuation method for companies that have significant intangible assets, such as intellectual property, brand recognition, or customer relationships. In summary, ABV is a useful method for valuing companies with tangible assets, and it can provide a conservative estimate of a company's value. However, it should be used in conjunction with other valuation methods and should be tailored to the specific circumstances of the company being analyzed. D. Economic Value Added (EVA) Analysis: This method involves calculating a company's net operating profit after tax (NOPAT) and subtracting the cost of capital to determine the company's economic value added. EVA is a measure of the company's profitability and can be used to assess its overall value. E. Dividend Discount Model (DDM): This method values a company's stock based on the present value of its expected future dividends The Dividend Discount Model (DDM) is a financial valuation method that calculates the present value of future dividends paid by a company. This model is based on the assumption that the value of a stock is equal to the sum of its future dividends, discounted back to their present value. To use the DDM, an analyst first estimates the future dividends that a company is expected to pay. This estimation can be based on the company's historical dividend payments, projected future earnings, or other factors. The analyst then applies a discount rate to the future dividends to account for the time value of money and the risk associated with the investment. The discount rate used in the DDM typically reflects the company's cost of equity, which is the expected rate of return that investors require to invest in the company's stock. This rate can be estimated using various methods, including the Capital Asset Pricing Model (CAPM) or the Dividend Growth Model. Once the future dividends and discount rate have been estimated, the analyst can calculate the present value of the expected dividends using the following formula: V = D / (1 + r) + D / (1 + r) ^ 2 + ... + D / (1 + r) ^ n where PV is the present value of the expected dividends, D is the expected dividend payment, r is the discount rate, and n is the number of periods in the future. The result of the DDM calculation is the intrinsic value of the stock, which can be compared to the current market price to determine whether the stock is undervalued or overvalued. It's important to note that the DDM is based on several assumptions, including the stability and predictability of future dividends, the discount rate used, and the accuracy of the earnings projections. Therefore, it should be used in conjunction with other valuation methods and should be tailored to the specific circumstances of the company being analyzed. F. Valuation multiples are ratios that are used to compare the value of a company to a relevant financial metric, such as earnings, revenue, or book value. These ratios are calculated by dividing the market value of the company by the financial metric being used. Valuation multiples can be useful in comparing companies within the same industry or sector and can help investors identify undervalued or overvalued stocks. Common valuation multiples include: 1. Price-to-Earnings (P/E) Ratio: This is the ratio of a company's current share price to its earnings per share (EPS) over the past 12 months. A higher P/E ratio indicates that investors are willing to pay more for each dollar of earnings, which may reflect higher growth prospects or a higher risk profile. 2. Price-to-Book (P/B) Ratio: This is the ratio of a company's current share price to its book value per share, which is the company's assets minus its liabilities. A lower P/B ratio may indicate that the company is undervalued relative to its assets. 3. Enterprise Value-to-Revenue (EV/R): This is the ratio of a company's enterprise value (which includes its market capitalization, debt, and preferred stock minus its cash and cash equivalents) to its revenue over the past 12 months. A lower EV/R ratio may indicate that the company is undervalued relative to its revenue. 4. Enterprise Value-to-EBITDA (EV/EBITDA): This is the ratio of a company's enterprise value to its earnings before interest, taxes, depreciation, and amortization (EBITDA) over the past 12 months. This ratio is often used in industries with high levels of capital expenditure, such as manufacturing or energy, and a lower ratio may indicate that the company is undervalued relative to its EBITDA. Valuation multiples can provide a quick and easy way to compare the relative value of companies within an industry or sector. However, it's important to note that these ratios are based on historical financial metrics and may not reflect future growth prospects or changes in the industry or macroeconomic conditions. Therefore, valuation multiples should be used in conjunction with other valuation methods and should be tailored to the specific circumstances of the company being analyzed.

What is ROCE and how is it calculated - The most comprehensive guide Need to Make strategic decisions - Use ROCE to guide you through Define Return on Capital Employed, abbreviated as ROCE, is ratio used to understand company’s capital efficiency, i.e. how efficient is the firm in generating profits from the capital it invests in the firm. What Formula? There are several formulas to calculate ROCE, and it depends on what one wants to use it for, what level of details are given and level of details required. Earnings before Interest and Tax/Capital Employed What Components? A. Capital Employed from Asset side of Balance sheet Capital employed = Total Assets – Current Liabilities, or Capital employed = Net Fixed Assets + Net Working Capital, where Net Fixed Assets = Gross PP&E + Additions – Disposals - Depreciation and Impairment B. Capital Employed from Liability side of Balance sheet Capital Employed = Shareholders Equity or funds + Total Debt or Net debt + Deferred Tax Liability Or, Net worth + Net Debt Or Add: If Lease is considered as Debt Where Shareholders Equity can be detailed as: Most comprehensive formula Notes 1. In case of US GAAP, remember: Add Operating Lease Liabilities and Current portion of Operating Lease to total Debt 2. Shareholders equity means Equity attributable to Parent i.e. do not add Non-controlling Interest Earnings Before Interest and Tax EBIT is what is presented in the annual report as Operating profit or EBIT = Adjusted EBIT, where adjusted EBIT calculated after removing one-time non-recurring and non-operating items of expense and income Always remember 1. Add back Non-recurring & one-time expenses, Unusual and Non-operating expenses Less Non-recurring & one-time expenses, Unusual and Non-operating incomes or gains Where can I find them - Financial Statement Linkages? Real Company Analysis - SGS Group Let’s take example, of SGS Group, a Swiss company engaged in Testing, Inspection and Certification business. We have taken numbers from annual reports from 2016 to 2022. The annual reports can be found at https://www.sgs.com/en/investor-relations Return on Capital Employed (CHF Million) Please feel free to pick your poison on which formula to use to calculate Capital Employed. The idea is simply to calculate total debt. EBIT ROCE = Adjusted EBIT / Capital Employed How to Interpret? As we can see from the example above, for every CHF 1 company employs it is able to earn operating profit on an average of 21 percent or in other words how much operating income is generated for each CHF 1. Also, important is comparison with some average or benchmark indicator. Comparison can be done in the following ways: 1. Temporal Comparison, i.e. time series trend analysis 2. Comparison with Industry benchmark 3. Comparison with Industry Average or close peers / competitors Remember when we compare ratios against any average it shall be calculated with same formula otherwise it will result in erroneous comparison. 1. Trend Analysis As can be seen from our example that SGS group has consistently performing with ROCE of above 20% except for 2020 with ROCE falling to 16% due to covid effect. 2. Comparison with Industry Average or close Peers: If you compare SGS group with its close peers like Intertek and Mistras it has faired better than Mistras but not with Intertek. Mistras ROCE Intertek ROCE Comparison with Close Peers But if we compare it with average ROCE of close peers, we find SGS Group has outperformed them by quite a margin, as seen from the table above. It is important to understand that when we compare ratio with peers/competitors, the selection of right peers/competitor is very important. Direct competitors which sell similar if not exactly same type of product or service, in terms of functionality and not form, shall only be compared. Also, when comparing peers’ careful consideration should be given about the share of fixed assets in total assets of the firm. For firms with high fixed asset as percentage of Total assets will have lower ROCE. What Strategic Implications Firms that have ROCE consistently above Weighted Average Cost of Capital (WACC) have sustainable competitive advantage. If we take the numerator of the ROCE ratio which is EBIT and break it further, we see it dependent on Price, Volume of product sold or frequency of services rendered and cost of service. Firms that can charge premium price or have lower costs will consistently perform better in terms of ROCE compared to WACC. How to forecast? To forecast ROCE we need to forecast Revenue, Operating Costs, Total Debt, and Shareholders funds. Shareholders funds are divided into key components for forecasting: 1. Share Capital 2. Treasury Shares 3. Additional Paid-in Capital 4. Share Premium 5. Reserves 6. Retained Earnings 1. Share capital can be forecasted using straight line method. If you want to get complex, then use additional funding requirement schedule. We need to create and 3-statement model to create such a schedule. We need to assume about what Debt equity ratio to find additional share capital or debt. We can also use the optimal capital structure model to forecast it. 2. Treasury Shares Treasury Shares is buy-back of shares by firms. To forecast it we can use either straight line method or look at for clues in annual reports Management Discussion & Analysis part where they discuss their plan for buy-back. But it more likely than not firms do not announce it in advance as it influences stock markets. 3. Additional Paid-in Capital Additional Paid-in capital is additional capital raised by companies. This is similar to share capital we do not need to forecast this and use the share capital schedule. 4. Share Premium If you have additional capital and assume to place at premium forecast, it using share capital requirement and premium that you will charge per share. Otherwise, use straight line forecast. 5. Reserves Reserves are divided into three types: a. General Reserve: Profits retained in business b. Specific Reserve: Like Debenture Redemption Reserve are type of reserve is maintained for a specific purpose c. Capital Reserves: Reserves created for specific purpose and can be used for that reason only Use straight line method to forecast reserves if details about specific purpose for which reserves were created not available. 6. Retained Earnings

Valuation is not just about numbers flashing across financial dashboards, but a story that follows strategy, economics, finance, financial standards, industry analysis, statistics, market research, and consumer behavior. So let's start the journey of the known and unknown about valuation, but first things first. Lets, go through the steps in valuation. This is divided into four sections: Market, Strategy, Forecasting and Finance and then connect each section to understand the Valuation numbers Market Connect Step 1: Characterize the company into an industry to which valuing company belongs Step 2: Understanding the industry characteristics - Porter Five forces Step 3: List and understand the business units into which the company that we value is divided Steps 4: Understand the consumer behavior from the market demand side for each business unit Step 5: List and analyze competitors in each business unit from the perspective of product and services, pricing, supply channels, promotion activities - The Marketing Mix Step 6: Create value and perception maps for each business unit Strategy Connect Step 1: At the corporate level, what strategy is the company following Step 2: At Business Level, what strategy is the company following and understand the elements of value it is propagating Step 3: Conduct Porter 5 forces analysis to understand the profitability of the company Step 4: Conduct competitor analysis to understand the competitive rivalry to understand the impact on revenues, costs and profitability Forecasting Connect Step 1: Forecast key financial parameters using regression or time series forecasting Step 2: Input forecasting output to forecast key financial parameters Finance Connect Step 1: Create basic layout of the valuation model Step 2: Input Historical data in the model - P&L, Balance Sheet, Cash flow statement and Schedules and notes Step 3: Understanding the accounting standards company follows to create financial numbers Step 4: Create Assumption sheet for forecasting financial statements and schedules Step 5: Input and Understand notes to accounts related to income statement, balance sheet, and cash flow statement to re-organize these statements Step 6: Re-organize income statement, balance sheet, and cash flow statement to estimate Net Profit After Tax (NOPAT) and Balance Sheet used for Discounted Cash Flows (DCF) calculation Step 7: Prepare Schedules to Accounts required to complete projected income statement, balance sheet and cash flow statement Step 8: Calculate Weighted Average Cost of Capital to discount Cash Flows Step 9: Estimate company value using Precedent Transactions and Comparable Trading Metrics Step 10: Collate Equity Research Analyst value estimates for the company Step 11: Determine value of a company using DCF methodology Step 12: Compare Valuation of company using different methods Photo Courtesy - Source: https://www.freepik.com/free-photos-vectors/business-valuation?log-in=google