Return on Equity (ROE) is regarded by many investors and several fund managers as one of the most important valuation ratios to consider when looking to invest in companies.
The problem lies in the fact that no one single valuation ratio is perfect and ROE has some notable flaws, which appear to be glossed over when commentators gush about its importance.
Firstly, some basics on how the return on equity ratio is calculated.
The basic ratio is Net Profit After Tax / Shareholders' equity
Book value and shareholders equity are interchangeable and refer to the net assets on a company's balance sheet. So total assets minus total liabilities will give you net assets/book value or shareholders equity.
Generally, the ROE ratio is calculated as the profit for the financial year divided by average of the starting equity and ending equity for the year.
What investors and fund managers look for is company's producing high returns on equity. Essentially it means that those companies generating high returns on equity are getting the best returns on the assets of the company.
Logically, it makes sense. Why own shares in a company that struggles to generate low returns on its assets?
The problem comes when the theory is put into practice, with a number of major issues including…
- Do you use underlying net profit, which adjusts for one-off expenses or gains, or statutory/reported profit?
- Companies with substantial debt balances can juice up their return on equity – because debt reduces the net equity in the business. Interest on the debt is also tax deductible – adding leverage to returns.
- Companies with substantial cash balances are penalised because it's virtually impossible to generate double-digit returns on cash. Cash also weighs on total equity.
- Companies with substantial intangibles such as goodwill, licences and trademarks are also penalised to some extent – because they aren't depreciated over time like normal physical assets.
- Higher capital intensive businesses generate lower returns on equity simply because they tend to have higher levels of assets.
- Some companies include hybrid securities and convertible notes as equity when they might need to be treated as debt for calculating ROE.
And some examples…
Using underlying profit makes sense, as that represents the 'real' net profit of the underlying business. Assets sales and writedowns are not normal everyday business activities for most companies. The problem comes when you have serial offenders who consistently record normal expenses as one-offs. Paper and packaging company Amcor Limited (ASX: AMC) consistently reports one-off expenses almost every year.
Amcor also has large levels of debt. The company has generated high ROE of above 40% in the past two years, but if you include debt, Amcor's return on invested capital is around 21%.
Flight Centre Travel Group Ltd (ASX: FLT) held $1.4 billion of cash on its balance sheet as of the end of June 2015 – but $813 million of it relates to deposits paid by customers for things like travel bookings before being paid out to suppliers. Flight Centre had an ROE of just over 20% last financial year but is clearly being penalised for having no debt and $1.4 billion of cash. Arguably, Flight Centre is a higher quality business than the capital intensive Amcor.
Wesfarmers Ltd (ASX: WES) has generated single-digit returns on equity since purchasing Coles in 2008 until it managed to achieve an ROE of 10.1% last financial year. The conglomerate has $19 billion of intangible assets on its books – around half its total assets – almost all related to the purchase of Coles. You could also argue that Wesfarmers is a better business than many others generating 10% returns on equity.
Platinum Asset Management Limited (ASX: PTM) generates a ROE of close to 60% simply because it doesn't need substantial amounts of assets to generate its returns. The fund manager's main assets are its people – and they don't appear on the balance sheet.
Foolish takeaway
Beware of market spruikers talking up the benefits of ROE without acknowledging the potential pitfalls. ROE is a useful valuation measure but has its limitations and shouldn't be used in isolation.
