Return on Equity - an Investigation

Wednesday, Feb 09 2011 by
6
Return on Equity  an Investigation

I do not profess to be an academic or a professional analyst, but I like to understand the numbers and ratios that I am looking at in terms of what they really mean and whether they can be misinterpreted or manipulated (by others!).

Received wisdom seems to have Return on Equity (RoE) as an accepted measure of how good a company is at delivering profits for shareholders, which seems fair enough.

In essence, it is calculated by dividing Net Income (Profit After Tax) by Net Assets (Equity funds (attributable to ordinary shares)) on the opening balance sheet. So, if you started with Net Assets of 100 and generated Net Income of 15, your RoE is 15% for the year (one of my Rules). (Note: I use the opening balance of Net Assets, but I have seen others who take an average of the opening and closing Net Asset position). 

Let's consider a worked example and I make no apologies for trying to keep it as simple as possible:

  • a company generates £10m of PAT each year for three years;
  • it has opening Net Assets (ordinary shareholders' equity; non-cash) of £50m; and
  • the Market values the company on a P/E of 12x PAT.
A Basic analysis looks like this:















BASIC  
Opening


Yr 1


Yr 2


Yr 3


ROE




"Value"



             

Unlock this article instantly by logging into your account

Don’t have an account? Register for free and we’ll get out your way

Disclaimer:  

IMPORTANT - this blog acts as a commentary for my own analysis of publicly available information on companies that interest me. It does not constitute any recommendation to buy or sell any shares or investments that I may or may not hold. If you want professional advice, go to a broker (who has the necessary authorisation and professional indemnity insurance!)


Do you like this Post?
Yes
No
6 thumbs up
0 thumbs down
Share this post with friends




18 Comments on this Article show/hide all

StockHound 9th Feb '11 1 of 18
2

Return on Capital is a much better figure to use to gauge the quality of a company. ROE is too skewed by the management's funding decision. The Little Book that Beats the Market uses ROCE to compare companies regardless of their capital structure.

On the other hand ROE is a very important tool when considering the rate of return the company is getting on it's retained earnings. Many years of retained profit compounded at a high ROE will make you as rich as Warren Buffett - and that's why he likes to keep an eye on it.

Every ratio has it's use, but it's very much about the right tool for the job.

A company like Domino's Pizza (LON:DOM), or Abcam (LON:ABC) has a consistently high ROE and ROCE and does a fantastic job for shareholders. Great companies, but expensive as a result. The trick is to find these great high return, self funded, compounding stocks early. I've a feeling the market in the UK latches on all too late to these stories, underpricing them early, and overpricing them late - trouble with the UK market is there aren't enough of these stocks to go around.

| Link | Share
10 Value 10 9th Feb '11 2 of 18
2

Hi StockHound

Thanks for your input. So the answer seems to be look at both ROE and ROCE. I guess ROE is useful as a screening measure, but doesn't remove the need to analyse the quality and sustainability of earnings (not that I ever intended it to) and understand how that translates to movements in ROE.

I've got the 'Little Book...' next up on my reading list, so will pay particular attention to that aspect.

Blog: 10 Value 10
| Link | Share | 1 reply
marben100 9th Feb '11 3 of 18
2

Hi 10 Value 10,

Nice article but I'd just like to raise a couple of points/possible misunderstandings:

  1. A dividend in shareholders' hands is very different to cash on the balance sheet. The former is something tangible for the shareholder. The latter... well you can't be sure what management will do with that cash. They might choose to pay themselves more, to squander it on an overpriced acquisition etc. Hence, in the real world, real cash dividends are much more meaningful/valuable than cash building up on the balance sheet. Of course, if a company has a track record of regularly distributing excess cash as special dividends, as well as ordinary ones, e.g. FW Thorpe (LON:TFW) , that may alter one's view of the value of cash on the balance sheet.
  2. Share buybacks don't alter a company's net assets except to the extent that they remove cash from the balance sheet (same impact on the balance sheet as paying dividends). What they do do is change assets and earnings per share. Setting tax considerations aside, buybacks (IMO and that of Warren Buffett) can be good or bad. It all depends what share price they're done at (as well as other factors such as existing cash/debt levels). If buybacks are used to support the price of an already overpriced stock, that won't add much to shareholder value and hence is bad. OTOH if stock is bought really cheaply and there's plenty of cash on the balance sheet, then that might add more shareholder value, by allowing higher dividends per share in the future. This is a question of judgement and, because their effectiveness depends on future results, they are inherently riskier than straightforward dividends.

To understand point 2, note that the equity in ROE = assets - liabilities, so whether the earnings are spent on buybacks or dividends they will not alter the "equity", though they do alter the number of shares in issue.

Cheers,

Mark

| Link | Share | 1 reply
StockHound 9th Feb '11 4 of 18
2

In reply to 10 Value 10, post #2

Really is an excellent book - the best of the series, and I've read a lot of them.

It promotes a simple maxim - buy 'good' companies at 'cheap' prices.

'Good' = high ROCE (he removes intangibles from the definition of capital)

'Cheap' = high earnings yield.

Most people think of the earnings yield as the inverse of the P/E ratio, but he uses EV / EBIT - so that the yield is independent of the capital structure of the business.

It's all very well saying the Market Cap of a company is £100m and the earnings are £10m (p/e 10 or 10% earnings yield) but if it's loaded up with £100m of debt then the earnings yield on the capital base is only (10/200 = 5) 5% - so comparing companies you have to compare like with like and including the debt makes sense. Enterprise Value therefore is better to use.

Back to ROE - there's a good article here which might be useful... http://www.aaii.com/journal/article/using-roe-to-analyze-stocks-what-you-need-to-know-about

| Link | Share | 1 reply
10 Value 10 10th Feb '11 5 of 18
2

In reply to marben100, post #3

Hi Marben

Many thanks for your comments.

1 - I quite agree. I was trying to compare like-with-like to see how 'value' flows. In reality, I like big, fat, sustainable dividends in my hands rather than see spare cash sitting on some balance sheet somewhere.

2 - The one thing I haven't quite figured out, is if a company spends £10m on buying back shares in the market to cancel, but these only have a nominal/asset cost of £4m, where does the other £6m go? SPA or other reserves?

Thanks

Blog: 10 Value 10
| Link | Share | 2 replies
10 Value 10 10th Feb '11 6 of 18
1

In reply to StockHound, post #4

StockHound

"buy 'good' companies at 'cheap' prices" - makes it all sound so easy! I'm looking forward to getting stuck in...

I tend to look at EV/EBITDA when I'm analysing. I know that Buffett et al do not like EBITDA, so I'll remain open-minded about using EBIT once I've finished the book.

Many thanks for the link to the article - it was very interesting and informative

Yorkiem



Blog: 10 Value 10
| Link | Share
marben100 10th Feb '11 7 of 18
2

In reply to 10 Value 10, post #5

Hi 10 Value 10,

where does the other £6m go

I'm not an accountant, but I guess the share capital account must reduce by the £4m and, I suppose, the balance affects the retained P&L. So, the sum of the "equity" part of the balance sheet would be the same as if the £10m had been paid out in divvies, when the whole £10m would be charged against retained P&L.

Cheers,

Mark



| Link | Share | 1 reply
tournesol 10th Feb '11 8 of 18
2

This all begs the question "does the figure included in the balance sheet for capital assets actually mean anything?"

IMHO, as far as oil companies and mining companies are concerned, the answer is a resounding "no".

the balance sheet shows historic expenditure less depreciation - that has nothing to do with "value" in any meaningful sense.

| Link | Share | 2 replies
marben100 10th Feb '11 9 of 18
1

In reply to tournesol, post #8

Hi T - I don't think we're really talking about junior oilies/miners here. Some pople do invest in other types of companies, you know. ;0)

The whole debate is really only applicable to "traditional" businesses, making profits from some form of trading activity. Junior oilies/miners have to be analysed by studying their assets, and, as you say, the balance sheet in of little use in doing that, except for the cash it shows.

Cheers,

Mark

| Link | Share | 1 reply
10 Value 10 10th Feb '11 10 of 18
1

In reply to marben100, post #7

Hi Mark

Yes, I agree that is the logical explanation and confirms that my scenario 3 is wrong. What foxed me was that I looked at a couple of examples (listed company balance sheets) and they had applied the cash amount (£10m) against ordinary shares rather than the nominal value. Anyway, I think I'm getting overly excited by it all, and will still to my conclusion that dividends, buy-backs and debt all have an impact on RoE and leave it at that!

Cheers

Blog: 10 Value 10
| Link | Share | 1 reply
10 Value 10 10th Feb '11 11 of 18
1

In reply to tournesol, post #8

Tournesoi

Good point! The fair value of assets rather than book value (and conversely off-balance sheet liabilities) takes us to a whole new dimension. Gulp

Blog: 10 Value 10
| Link | Share | 1 reply
marben100 10th Feb '11 12 of 18
1

In reply to 10 Value 10, post #10

Hi 10V10,

I think the most important "take-away" is one that Ben Graham and WB have tried to explain and few commentators that I''ve come across really understand, which is this:

Whilst things like ROE and ROCE are OK for screening, when it actually comes to comparing specific companies as potential value investments, you've got to do some hard graft and dig into the accounts. You have to look beneath the headline numbers and decide what the real numbers for "profits", "capital employed", "debt" etc are. They can be very different from the headline numbers.

For example, I am very wary of "goodwill", which AFAIAC is an accounting fiction, so I tend to disregard it. With debt, you need to consider things like onerous leases, pension schemes etc. When it comes to depreciation, does the figure match sustaining CAPEX? If it does, then that CAPEX is a REAL cost of the business and cannot be disregarded in profit calculations. Of course, you have to form your own judgement of what CAPEX is sustaining and what is investment that will grow the business. There are similar issues surrounding amortisation - is it a real cost or an artificial adjustment? This is why Buffett is wary of EBITDA, which may flatter profits by hiding real costs.

Of course, investigating all these details is hard work and making all these judgements requires experience/knowledge. Your reward, however, is that you may discover something that the "herd" hasn't understood and has led to a mispricing of a company's shares (especially with smaller companies that tend to be more poorly analysed). Succesful investing isn't easy and that's something many people fail to understand.

Best,

Mark

| Link | Share
10 Value 10 10th Feb '11 13 of 18
1

Mark

Great summary.

What I'm trying to do on my blog is to delve into the next level of detail on potential investment opportunities, rather than take stuff at face value, to make sure that I understand the key drivers and inter-relationships.

Some commentators tend to treat things like ROE as a sacred cow which tells tell them everything, but the outcome of my investigation, and subsequent discussion, confirms to me that this is not necessarily the case.

I am under no illusions about the hard work!

Many thanks for your input

Blog: 10 Value 10
| Link | Share
nigelpm 10th Feb '11 14 of 18
2

In reply to 10 Value 10, post #5


2 - The one thing I haven't quite figured out, is if a company spends £10m on buying back shares in the market to cancel, but these only have a nominal/asset cost of £4m, where does the other £6m go? SPA or other reserves?


You have to reduce share premium/cap red reserve or other.

| Link | Share
nigelpm 10th Feb '11 15 of 18
3

In reply to 10 Value 10, post #11


(and conversely off-balance sheet liabilities)


Which is going to get more interesting - certainly for retail companies - with the upcoming change to IFRS which will require operating leases to be disclosed on the balance sheet.

 

Going back to the original post, the more I've learnt (nearly finished my three years chartered accoutancy training) throughout my time the more I hate ratios - they are too easy to manipulate and/or fudge.  PTBV is still a favourite though assuming the intangibles have been stripped out.

| Link | Share | 1 reply
10 Value 10 10th Feb '11 16 of 18
1

In reply to nigelpm, post #15

Thanks Nigel

It's a while since I did my exams and it's a case of the more you learn, the more you forget!

In a nut-shell, how are the operating leases going to be disclosed/capitalised? For banking covenants, the rents get capitalised (8 times from memory) and measured against rent-adjusted EBITDA (EBITDAR), so the banks should get their heads around it, but I can see it spooking lots of investors and analysts

Blog: 10 Value 10
| Link | Share
nigelpm 10th Feb '11 17 of 18
1

see :

http://www.icaew.com/en/technical/financial-reporting/ifrs/ifrs-standards/ias-17-leases

The ED proposes that there is no longer a distinction between finance and operating leases, and instead a new 'right of use' approach is based on the principle that all leases give rise to liabilities for future rental payments and a right to use the underlying asset that should be recognised in an entity’s statement of financial position.

i.e. capitalisation.

| Link | Share
emptyend 11th Feb '11 18 of 18
3

In reply to marben100, post #9

I don't think we're really talking about junior oilies/miners here. Some pople do invest in other types of companies, you know. ;0)

The whole debate is really only applicable to "traditional" businesses, making profits from some form of trading activity. Junior oilies/miners have to be analysed by studying their assets, and, as you say, the balance sheet in of little use in doing that, except for the cash it shows.

I might just point out that Tournesol's caution about "does the figure included in the balance sheet for capital assets actually mean anything?" actually isn't just limited to oil companies and miners.

It also affects assets such as property - which are very commonly held in the balance sheet at cost and are not revalued from one decade to the next!

The bottom line is that if one is looking at any company which may have a significant chunk of its value tied up in physical (sellable) assets then one should expect to make adjustments to the assets reported in the balance sheet!

The difference between miners etc and property assets is that property assets can be revalued relatively easily if a company so chooses, whereas the value of assets in the ground is always a matter of judgement - until the point where the assets themselves are sold in the market.

ee

ps..this is also a reason why bank lending based on oil reserves etc is relatively uncommon, because bank estimates of asset values tend to be extremely cautious (so they will lend relatively little and, in the event of them calling in their loan, companies may face a considerable loss of value because the bank has been excessively cautious in their assessment of asset value. This is a similar situation to a bank getting a charge over a property at 50-60% of market value, as would be the case with a mortgage backed by a lot of equity.......if the bank forecloses, they are only concerned about recovering the amount of the outstanding mortgage - and don't care in the slightest about protecting the remaining equity of the foreclosee)

| Link | Share

What's your view on this article? Log In to Comment Now

You can track all @StockoChat comments via Twitter


About 10 Value 10

10 Value 10

I am a private investor, who happens to be a Chartered Accountant with experience in corporate finance, venture capital and banking. Living in Yorkshire has driven my desire to find value in all things even further! more »


Stock Picking Tutorial Centre



Let’s get you setup so you get the most out of our service
Done, Let's add some stocks
Brilliant - You've created a folio! Now let's add some stocks to it.

  • Apple (AAPL)

  • Shell (RDSA)

  • Twitter (TWTR)

  • Volkswagon AG (VOK)

  • McDonalds (MCD)

  • Vodafone (VOD)

  • Barratt Homes (BDEV)

  • Microsoft (MSFT)

  • Tesco (TSCO)
Save and show me my analysis