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KembaraXtra–Islamic Finance–Islamic Capital Market – ROE Based on Dividend Policy (Simple Explanation with Calculation)
How Dividend Policy is Linked to ROE
Return on Equity (ROE) can also be understood through a company’s dividend policy, especially when a firm retains part of its earnings instead of distributing all profits as dividends. This approach is commonly used in long-term growth analysis and is consistent with equity-based, risk-sharing principles emphasised in Islamic finance.
The key idea is:
- Retained earnings are reinvested in the business
- These reinvested earnings generate future profits
- The efficiency of this process is reflected in ROE
Key Terms You Need to Know
- Dividend Payout Ratio (DPR):
Portion of earnings paid out as dividends
\text{Dividend Payout Ratio} = \frac{\text{Dividends}}{\text{Net Income}} - Retention Ratio (b):
Portion of earnings retained in the business
b = 1 - \text{Dividend Payout Ratio} - Growth Rate of Dividends (g):
The rate at which dividends are expected to grow over time
ROE Determination Using Dividend Policy
ROE can be derived using the following relationship:
\{ROE} = {g}/{b}
Where:
- g = growth rate of dividends (or earnings)
- b = retention ratio
This formula assumes that:
- Growth is funded internally (no excessive borrowing)
- Retained earnings are the main source of equity growth
Simple Numerical Example
Assume a company has:
- Dividend payout ratio = 40%
- Retention ratio (b) = 60%
- Dividend growth rate (g) = 12%
Now calculate ROE:
{ROE} = {12\%}{0.60} = 20\%
Interpretation:
The company is generating a 20% return on shareholders’ equity by reinvesting 60% of its profits back into the business.
Why This Makes Sense
- Higher retention ratio → more reinvestment → higher future profits
- Efficient reinvestment → higher ROE
- Poor reinvestment decisions → low or declining ROE
This highlights that ROE is not just about profits, but about how wisely retained earnings are used.
Link to Islamic Finance
- Islamic finance emphasises profit-and-loss sharing, not guaranteed returns
- Retained earnings represent real investment in productive assets
- ROE derived from dividend policy reflects true business performance, not interest-based income
- This aligns closely with Musharaka-style equity participation
Key Takeaways
- ROE can be estimated using dividend growth and retention policy
- A firm with high growth and smart reinvestment will show high ROE
- Retaining earnings only adds value if reinvestment is productive
- This approach supports ethical, asset-based, and risk-sharing investment, which is central to Islamic capital markets
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KembaraXtra–Islamic Finance–Islamic Capital Market – Return on Equity (ROE) Explained Simply
What is Return on Equity (ROE)?
Return on Equity (ROE) shows how much profit a company makes using the money invested by its shareholders. It is calculated by dividing the company’s annual net income by its total shareholders’ equity and is expressed as a percentage. In simple words, ROE tells investors how many dollars of profit are generated for every dollar of shareholders’ money.
Basic Formula
- ROE = Net Income ÷ Shareholders’ Equity
- Shareholders’ equity includes share capital plus retained earnings.
Alternative Understanding of ROE
ROE can also be understood through a company’s dividend policy. If a company retains more earnings instead of paying dividends and uses them effectively, its ROE tends to be higher. This approach links the income statement (profits) with the balance sheet (equity), making ROE a two-part measure of performance.
Simple Meaning
If a company has an ROE of 10%, it means the company earns 10 cents of profit for every 1 dollar of shareholders’ equity.
Related Valuation Measures
- Price-to-Book (P/B) Ratio = Stock Price ÷ Book Value per Share
- ROE = Net Income ÷ Average Shareholders’ Equity
The book value per share is calculated by dividing total shareholders’ equity by the number of outstanding shares.
Relationship Between ROE and P/B Ratio
Companies with higher growth and stronger profitability generally have higher P/B ratios. This is because investors are willing to pay more than book value for firms that generate high returns from their equity.
Simple Example
- If a company has equity of USD 100 million and earns USD 20 million in profit, its ROE is 20%.
- Investors may value such a company at 2–3 times its book value because of its strong profitability.
Real-World Illustration (Simplified)
A well-known company once recorded an ROE of about 25% and traded at three times its book value. When its ROE later declined into negative territory, investors lost confidence and the stock price fell close to its book value. This shows how strongly ROE influences market valuation.
Important Clarification
- A high P/B ratio does not always guarantee a high ROE, but
- A consistently low P/B ratio often signals weak ROE and poor asset performance.
Key Takeaway
ROE measures how effectively a company uses shareholders’ money to generate profits. Investors prefer companies with strong and stable ROE, and this preference often leads to higher share prices and higher P/B ratios, especially for well-managed and Shari’ah-compliant firms.
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KembaraXtra–Islamic Finance–Islamic Capital Market – Relationship Between P/E, ROE, and P/B Ratios
Big Picture (One-Line Idea)
ROE explains profitability, P/B reflects how the market values that profitability, and P/E shows how much investors are willing to pay for those earnings. All three ratios are connected and should be read together, not separately.
1. Role of Return on Equity (ROE)
- ROE measures performance
- It shows how efficiently a company uses shareholders’ equity (share capital + retained earnings) to generate profit
- Higher ROE = better use of shareholders’ funds
Simple example:
If a company earns USD 20 million using USD 100 million of equity → ROE = 20%
2. How ROE Influences P/B Ratio
- P/B measures valuation of net assets
- Investors are willing to pay more than book value if a company generates high ROE
- Therefore:
- High ROE → Higher P/B
- Low ROE → Lower P/B
- Company A: ROE = 18% → P/B = 3
- Company B: ROE = 6% → P/B = 1
Investors value Company A more because it earns more from the same equity base.
3. How ROE Influences P/E Ratio
- P/E measures valuation of earnings
- Companies with high ROE usually have:
- Strong profitability
- Better growth expectations
- Investors are willing to pay more per dollar of earnings
So:
- High ROE → Higher P/E
- Low ROE → Lower P/E
4. Direct Relationship Between P/B and P/E
There is a mathematical and economic link between P/B and P/E through ROE:
P/B ≈ P/E × ROE
This means:
- For the same P/E, a company with higher ROE should have a higher P/B
- For the same P/B, a company with higher ROE should justify a higher P/E
5. Simple Combined Example
Assume two Shari’ah-compliant companies:
Company X (Efficient)
- ROE = 20%
- P/E = 12
- Implied P/B ≈ 12 × 0.20 = 2.4
- ROE = 8%
- P/E = 12
- Implied P/B ≈ 12 × 0.08 = 0.96
Even with the same P/E, Company X deserves a higher P/B because it uses equity better.
6. What Investors Learn by Using All Three Together
- ROE answers: “How good is management at generating profits?”
- P/B answers: “How much am I paying for the company’s net assets?”
- P/E answers: “How much am I paying for the company’s earnings?”
Used together, they help investors avoid mistakes such as:
- Buying a low P/E stock with weak ROE (value trap)
- Overpaying for high P/B stocks without strong ROE support
7. Islamic Finance Perspective
- Islamic equity investing emphasises real assets, equity, and risk-sharing
- ROE reflects genuine business performance (not interest leverage)
- P/B aligns with asset-backed valuation
- P/E reflects fair pricing of halal earnings
👉 ROE drives value, P/B reflects asset valuation, and P/E reflects earnings valuation.
A strong Shari’ah-compliant company typically shows high ROE supported by reasonable P/E and P/B ratios.
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KembaraXtra–Islamic Finance–Islamic Capital Market – Price-to-Book (P/B) Ratio and Return on Equity (ROE)
What is the Price-to-Book (P/B) Ratio?
The price-to-book (P/B) ratio compares a company’s market value with its book value. In simple terms, it shows how much investors are willing to pay for each dollar of the company’s net assets. It is an equity valuation ratio commonly used to assess whether a stock is cheap or expensive relative to what the company owns on paper.
Simple Formula
P/B Ratio = Market Price per Share ÷ Book Value per Share
What is Book Value (in simple words)?
Book value represents the net worth of a company according to its balance sheet. It is calculated as:
- Total assets minus liabilities
- Often excludes intangible items like goodwill and patents
- Reflects the theoretical value shareholders would receive if the company were liquidated
On a per-share basis, book value tells us how much equity backs each share.
Simple Example of Book Value
Assume a company has:
- Total assets = USD 1,000 million
- Total liabilities = USD 700 million
Book value (shareholders’ equity) = 1,000 − 700 = USD 300 million
If the company has 100 million shares, then:
Book value per share = 300 ÷ 100 = USD 3
Simple Example of P/B Ratio
If the market price of the share is USD 6 and the book value per share is USD 3:
P/B Ratio = 6 ÷ 3 = 2.0
This means investors are willing to pay 2 times the company’s book value for its shares.
How to Interpret the P/B Ratio
- P/B
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KembaraXtra–Islamic Finance–Islamic Capital Market – Introduction
-Conventional financial systems were severely affected by the global financial crisis,particularly during the subprime mortgage crash of 2007–2008
-The Islamic financial system,which is Shari’ah-compliant,has evolved steadily since its inception and began adopting modern financial practices from the mid-1970s
-Over time,Islamic finance has emerged as a credible and successful alternative to conventional financial structures
-Shari’ah principles emphasise risk-sharing and discourage interest-based financing
-Instead of interest-based contracts,Islamic finance promotes Mudarabah and Musharaka as profit-and-loss-sharing instruments
-Risk-sharing is a core foundation of Islamic finance and is aimed at equitable and productive distribution of financial risk
-This concept of risk-sharing is not limited to Islamic finance alone but is beneficial for the broader economy
-Equity markets are considered ideal platforms for practising risk-sharing
-Stock markets inherently involve risk-sharing since investors share in profits and losses through equity ownership
-Globally,equity markets are generally well-organised,regulated,and long-established
-Many Islamic jurists permit investment in modern joint-stock companies provided they comply with Shari’ah norms
-Shari’ah screening is mandatory to determine whether stocks are permissible for Islamic investors
-Screening ensures investments align with Islamic ethical and legal principles
-Companies involved in tobacco,alcohol,gambling and gaming,conventional insurance,and interest-based finance are excluded from Islamic portfolios
-Sectors such as non-compliant entertainment,hotels,and weapons are also excluded from ethical Islamic investments
-Financial ratio screening is applied to limit involvement in interest-based activities
-These ratios assess interest-based debt,interest income,cash holdings,and receivables
-All Islamic investment funds and portfolios must maintain full Shari’ah compliance
-The growth of Islamic equity investments is driven not only by an increase in Shari’ah-compliant companies but also by diversification of equity instruments
-Islamic equity instruments include unit trusts or mutual funds,REITs,ETFs,venture capital funds,investment funds,and structured products based on Shari’ah indices
-All Islamic equity products must be structured strictly in accordance with Shari’ah principles
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KembaraXtra–Islamic Finance–Islamic Capital Market – Challenges Faced by the Islamic Capital Market
-Islamic financial businesses operate under distinct Shari’ah-based rules, which differ fundamentally from traditional business operations
-One major challenge is that the Islamic capital market is often required to comply with regulatory frameworks originally designed for conventional financial systems
-These conventional regulations are based on different objectives and philosophies, such as interest-based financing, which do not align with Islamic principles
-As a result, Islamic capital market institutions may face regulatory mismatch and operational constraints
-The Islamic capital market is relatively young and still evolving, whereas the conventional capital market has existed and developed over several centuries
-Both markets currently operate within the same financial and economic environment, creating competitive and structural challenges for Islamic finance
-The long-established dominance of the traditional capital market makes it difficult for the Islamic capital market to expand rapidly and gain equal footing
-Key takeaway:The Islamic capital market faces challenges due to regulatory incompatibility and its relatively early stage of development compared to the long-established conventional capital market
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KembaraXtra–Islamic Finance–Islamic Capital Market – Regulatory and Legal Frameworks of the Islamic Capital Market
-The Islamic capital market is regulated by government authorities in line with standards set by Islamic Financial Services Board (IFSB) and Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)
-Because the Islamic capital market is still at an early stage of development, its regulatory and legal frameworks are also continuously evolving
-In most countries,the conventional capital market authority supervises both conventional and Islamic capital markets
-Despite this,Islamic capital markets also rely on Shari’ah Supervisory Boards (SSBs),which are specifically responsible for Shari’ah-related matters
-All Islamic Financial Institutions (IFIs) must be carefully regulated and monitored to protect investors’ funds from intermediary failures,ensure fair redistribution,and prevent financial crimes
-Regulatory objectives are achieved through:regulation of securities,regulation of financial institutions,and strong corporate governance at the highest level
-The unique structure of IFIs,which combines financial and Shari’ah principles,makes standard-setting and regulation more complex
-This uniqueness explains why divergent opinions exist on how Islamic financial institutions should be supervised and regulated
-Despite these challenges,significant progress has been made toward global harmonisation of Islamic financial regulation
-Key international Islamic financial infrastructure institutions working toward harmonisation include:Islamic Financial Services Board,Accounting and Auditing Organization for Islamic Financial Institutions,Liquidity Management Centre,International Islamic Financial Market,International Islamic Liquidity Management Corporation,andInternational Islamic Rating Agency
-A strong legal framework is essential to protect the Islamic capital market from misuse arising from system ambiguities
-Legal protection prevents unfair exploitation and strengthens investor confidence
-There is a strong relationship between legal protection of financiers and economic development
-Effective enforcement of legal rules positively influences the size,depth,and growth of the Islamic capital market
-Key takeaway:strong legal enforcement and harmonised regulation are critical for the long-term growth,credibility,and stability of the Islamic capital market
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KembaraXtra–Islamic Finance–Islamic Capital Market – Liquidity Issues in the Islamic Capital Market
-Liquidity meaning:Ability to convert Islamic investments into cash quickly without significant loss in value
-Why liquidity matters:Investors need confidence to meet current and future financial obligations
-Unique liquidity challenge in ICM:Islamic investors face liquidity constraints not commonly faced in conventional markets due to the developing nature of the Islamic capital market
-Slower growth of Islamic products:Fewer Islamic financial instruments exist compared to conventional markets, limiting the availability of highly liquid assets
-Cause 1:Smaller market share:Islamic investments form a relatively small portion of global capital markets, leading to fewer participants, lower trading volume, and reduced liquidity, making resale of Islamic stocks or Sukuk slower
-Cause 2:Shari’ah compliance requirements:Mandatory business activity and financial ratio screening, along with differing scholarly opinions, slows product approval, listing, and development, affecting market liquidity
-Cause 3:Limited market access and infrastructure:Islamic capital market infrastructure is unevenly developed globally, restricting cross-border access and reducing investors’ ability to convert assets into cash quickly;for example, UK investors may struggle to access US-based Islamic assets
-Overall impact on investors:Higher liquidity risk,longer investment holding periods,and possible price discounts when selling assets
-Key takeaway:Liquidity remains a major structural challenge in the Islamic capital market,and strengthening market depth,access,and infrastructure is essential for long-term growth
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KembaraXtra–Islamic Finance–Islamic Capital Market – Flow of Funds in the Islamic Capital Market
1. Financial Architecture in an Economy
- There are two major types of financial systems:
- Bank-based system
- Banks are the main source of external finance.
- In Islamic finance, this role is played by Islamic Financial Institutions (IFIs).
- Market-based system
- Firms raise funds directly from the public through capital markets.
- Financing is done by issuing equity and Shari’ah-compliant debt instruments (e.g. Sukuk)
- Bank-based system
- The Islamic capital market (ICM) follows a market-based system but strictly complies with Shari’ah principles.
2. Replacement of Interest with Profit Sharing
- The Islamic capital market prohibits interest (riba).
- Instead of fixed interest:
- Returns are generated through profit-sharing arrangements.
- Investors earn returns only if the underlying business performs well.
- There is no guaranteed or pre-fixed increment on investments.
3. Savings Surplus Units (SSUs)
- Savings Surplus Units (SSUs) are individuals or entities whose:
- Income > Expenditure
- Characteristics of SSUs:
- They accumulate surplus wealth.
- They are obligated to pay Zakah if their wealth exceeds Nisab.
- Why SSUs must invest:
- Idle wealth reduces due to Zakah.
- To avoid wealth erosion and earn halal returns, SSUs invest in:
- Real economic activities
- Shari’ah-compliant capital market instruments (shares, Sukuk, funds
4. Savings Deficit Units (SDUs)
- Savings Deficit Units (SDUs) are consumers or firms whose:
- Expenditure > Income
- Mathematical representation:
- For consumers:
- (t −)
- For consumers:
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KembaraXtra–Islamic Finance–Islamic Capital Market – Islamic Mutual Funds vs Islamic Mixed Funds
Islamic Mutual Funds
-Invest in one main asset class or a focused strategy,most commonly Shari’ah-compliant equities or Sukuk
-All investments must strictly pass Shari’ah qualitative and quantitative screening
-Funds are structured similarly to conventional mutual funds but without riba,gharar,and maisir
-Investors receive units,and fund value is calculated using Net Asset Value (NAV)
-Returns are mainly generated from capital gains and halal dividends
-Risk level depends on the specific fund type (equity funds are riskier than Sukuk funds)
-Liquidity is moderate,as units are usually redeemable at NAV on a daily or periodic basis
-Suitable for investors seeking focused exposure to a specific Shari’ah-compliant asset class
Example:
-An Islamic equity mutual fund investing only in Shari’ah-compliant listed companies
Islamic Mixed Funds
-Invest in a combination of asset classes,such as equities,Sukuk,leasing (Ijarah),and commodities
-Designed to provide diversification within a single fund
-Trading of fund units in the market is permitted only if tangible assets constitute at least 51% of the portfolio
-Liquid assets and debts must not exceed 49%,to comply with Shari’ah rules on tradability
-Returns come from multiple sources,including equity appreciation,rental income,and Sukuk returns
-Risk profile is generally balanced,as losses in one asset class may be offset by gains in another
-Liquidity is moderate to low,and generally lower than pure Islamic mutual funds
-Suitable for investors seeking risk diversification and balanced growth
Example:
-A mixed Islamic fund investing in Shari’ah-compliant equities,Sukuk,and leased real estate assets
Key Differences
-Islamic mutual funds focus on specialisation,while Islamic mixed funds focus on diversification
-Islamic mutual funds rely mainly on NAV-based redemption,whereas Islamic mixed funds may involve market negotiation depending on asset composition
-Islamic mixed funds must observe the 51% tangible asset rule,which is not a specific requirement for Islamic mutual funds
-Risk in Islamic mutual funds is more concentrated,while risk in Islamic mixed funds is more spread across assets
Simple Conclusion
-Islamic mutual funds are ideal for targeted Shari’ah-compliant investing
-Islamic mixed funds are suitable for investors seeking diversified,asset-backed,and balanced Islamic investments
Islamic Mutual Funds
-Invest in one main asset class or a focused strategy,most commonly Shari’ah-compliant equities or Sukuk
-All investments must strictly pass Shari’ah qualitative and quantitative screening
-Funds are structured similarly to conventional mutual funds but without riba,gharar,and maisir
-Investors receive units,and fund value is calculated using Net Asset Value (NAV)
-Returns are mainly generated from capital gains and halal dividends
-Risk level depends on the specific fund type (equity funds are riskier than Sukuk funds)
-Liquidity is moderate,as units are usually redeemable at NAV on a daily or periodic basis
-Suitable for investors seeking focused exposure to a specific Shari’ah-compliant asset class
Example:
-An Islamic equity mutual fund investing only in Shari’ah-compliant listed companies
Islamic Mixed Funds
-Invest in a combination of asset classes,such as equities,Sukuk,leasing (Ijarah),and commodities
-Designed to provide diversification within a single fund
-Trading of fund units in the market is permitted only if tangible assets constitute at least 51% of the portfolio
-Liquid assets and debts must not exceed 49%,to comply with Shari’ah rules on tradability
-Returns come from multiple sources,including equity appreciation,rental income,and Sukuk returns
-Risk profile is generally balanced,as losses in one asset class may be offset by gains in another
-Liquidity is moderate to low,and generally lower than pure Islamic mutual funds
-Suitable for investors seeking risk diversification and balanced growth
Example:
-A mixed Islamic fund investing in Shari’ah-compliant equities,Sukuk,and leased real estate assets
Key Differences
-Islamic mutual funds focus on specialisation,while Islamic mixed funds focus on diversification
-Islamic mutual funds rely mainly on NAV-based redemption,whereas Islamic mixed funds may involve market negotiation depending on asset composition
-Islamic mixed funds must observe the 51% tangible asset rule,which is not a specific requirement for Islamic mutual funds
-Risk in Islamic mutual funds is more concentrated,while risk in Islamic mixed funds is more spread across assets
Simple Conclusion
-Islamic mutual funds are ideal for targeted Shari’ah-compliant investing
-Islamic mixed funds are suitable for investors seeking diversified,asset-backed,and balanced Islamic investments
