Why Return on Equity (ROE) is not meaningful for Stock Market Investors!

Modified on November 1, 2018

I thank my friend, Saurabh Dwivedi, for bringing up this topic and initiating this debate.

We (Saurabh & I) believe that Return on Equity (ROE) is not a true indicator of attractiveness of a stock for an investor. We believe that an investor should not be swayed by tall claims of ROE by company managements. Instead, she should use other parameters while deciding to invest in a stock. However, before delving deeper into this discussion, let us get a primer on ROE.

Return on Equity (ROE)/Return on Net Worth (RONW)

ROE is one of the measures of profitability of a company, which indicates how much profits the company is making from shareholder’s equity/net worth invested in the business. The simple formula to calculate ROE is:

 

ROE = Net profit after tax (PAT) / Shareholder’s equity (Equity)

 

Net profit after tax (PAT), a.k.a. bottomline, is the profit of the company that remains to shareholders after meeting all expenses, interest, provisions, taxes etc. Alternatively, PAT is the money earned, which a company can either distribute to its shareholders as dividend or retain to invest for future growth. PAT per share is known as Earnings Per Share (EPS). EPS = PAT/No. of shares

Shareholder’s equity (Equity) is the amount of money invested in the company that belongs to common shareholders. We learned during Financial Analysis of a Companythat any company uses a mix of own funds (Equity) and borrowed funds (Debt) to buy assets, which it utilizes to generate. Own funds of shareholders constitute both, the money put by shareholders from their pocket and the profits earned by the company over the years but not distributed to shareholders as dividends (Retained Earnings). Equity per share is known as Book Value Per Share (BVPS).  BVPS = Shareholder’s Equity/No. of shares

If company A has equity of INR 100cr (1.0 billion) and earns INR 10cr (0.1 billion) in profits, then its ROE would be 10% (10/100). Whereas company B which earns profits of INR 20cr (0.2 billion) by employing equity of INR 100cr (1.0 billion) would have an ROE of 20% (20/100).

ROE can also be represented as Earnings per share (EPS)/Book value per share (BVPS)

ROE = (PAT/No of shares = EPS) / (Equity/No. of shares = BVPS)

 

If company A & B both have 10cr (0.1 billion) shares, then EPS & BVPS of A would be INR 1 & INR 10 respectively and EPS & BVPS for B would be INR 2 & INR 10 respectively. ROE (EPS/BVPS) for A is 10% and B is 20%.

Under general opinion, a company with higher ROE should be a preferred investment, as it seems to employ its equity in a more productive manner. Therefore, in the above example, company B should be preferred over company A while making investment decision.

However, we differ from this simplistic interpretation and believe that ROE is not a valuable parameter for stock investor and it should be ignored by her.

 

Whether ROE is meaningful for stock market investors 

ROE can be meaningful to shareholders only until the time they are not exposed to the all-powerful forces of market price determination i.e. ROE can be useful for shareholders of unlisted private entities where shareholders are original investors who had put in initial capital. Original shareholders get the shares at BVPS. However, shareholders who buy the shares after the company has started its operations, rarely get them at book value. Shares are bought by them at either premium or discount to the BVPS and very rarely at BVPS. Premium or discount to BVPS happens because multiple factors concerning future growth of the company, like industry growth, MOAT etc, influence the transaction price of shares in subsequent purchases.

Once the offering price of shares differs from BVPS, ROE loses its significance for intended purchaser.

We witnessed earlier that by standard interpretation of ROE, company B with an ROE of 20% should be preferred over company A with an ROE of 10%. Let us assume that market participants believe the same and generate huge demand for shares of company B and current market price (CMP) of B rises to INR 20 against its BVPS of INR 10. Now any stock investor interested to buy shares of company B would have to shell out INR 20 for each share.

If the investor buys shares of company B, then she would hold a share of B costing INR 20 having an EPS of INR 2. The effective profitability ratio for her would not stay at ROE levels of 20%, as per earlier calculations of EPS/BVPS or PAT/Equity. Instead, Effective profitability ratio applicable for her now would be 10% (EPS of INR 2/Acquisition cost of INR 20). This is an example of buying a stock with perceived excellent value at a premium.

Similarly, if market ignores company A (having lower ROE of 10%) and reduces demand of its shares, current market price (CMP) of its shares would decline. Let us assume that CMP of its shares falls to INR 5 against its BVPS of INR 10. Any investor buying shares of company A at CMP would hold a share costing her INR 5, which generates an EPS of INR 1. For her, this share of company A would have an effective profitability ratio of 20% (EPS of INR 1/Acquisition cost of INR 5) rather than ROE of 10%, as per calculations of EPS/BVPS or PAT/Equity. This is an example of buying a stock with perceived average value at a discount.

As market price of shares of any company keeps fluctuating all the time, every stock market investor buys its shares at a different price. Therefore, the effective profitability ratio for each investor of a company differs from other investors depending upon her buying price.

If an investor gets the opportunity to buy a seemingly average company at significant discount, then she could get a high effective profitability from her stock than another investor who buys another company with seemingly excellent value at a significant premium. This is the basic premise of Value Investing. An investor should always try to buy a share cheap so that she can get maximum profitability out of her investment. Warren Buffett also says that:

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

To differentiate whether an investor is buying a wonderful company at fair price or a fair company at wonderful price, she needs to look at the effective profitability ratio at her buying price.

ROE in its standard definition does not factor in the buying price for a stock market investor. It is simply a ratio of two accounting concepts of PAT & Equity, which totally ignore the market pricing dynamics; a very powerful force affecting future returns for an investor. Therefore, ROE is meaningless for a stock market investor.

A wonderful company (with high ROE) if bought at a very high price would mean that market has already priced the future growth of this company in its CMP and scope of significant future price increase is low, as reflected by low effective profitability ratio. Similarly, a fair company (with average ROE), if bought at a significant discounted price would ensure that the investor gets a very high effective profitability from her investment and her portfolio can experience good amount of future price increase.

Hence, we should tweak the formula of ROE to make is useful for a stock market investor. We should replace the BVPS with acquisition price of an existing investor or with current market price (CMP) for a potential investor.

EPS

                                             _______________________________   = Effective Profitability Ratio

CMP/Acquisition cost of share

Effective profitability ratio is a better and meaningful parameter for any investor to consider before making investment in stock of any company.

Effective profitability ratio is commonly known as Earnings Yield (EY).

For investors who are familiar with bond markets can relate the difference between ROE and EY to the difference between Coupon Rate and Yield. From an investor’s perspective in bond markets, Yield is more meaningful than Coupon Rate. Similarly, for a stock investor EY is more meaningful than ROE.

There are many other reasons due to which ROE is not considered a very accurate parameter by investors.

  • Some of these reasons relate to the ineffectiveness of Equity to reflect true nature of net worth e.g. inclusion of intangible assets like goodwill, unrealized increase in assets like appreciation in land assets, unimpaired obsolete inventory of finished goods etc. 
  • Other reasons include management’s ability to increase ROE simply by increasing leverage (reflected by Dupont’s Analysis).

These additional factors further undermine the concept of reliance on ROE while making investment decision by a stock market investor.

Therefore, we believe that, while making investment decisions, rather than focusing on stocks with high ROE as per conventional wisdom, an investor should focus on stocks that provide her high effective profitability or Earnings Yield.

Addendum

I thank all the readers who spent their time to provide their views about the article. These inputs are highly appreciated. I have compiled the gist from the readers’ inputs & my responses and added it as part of the article: 

ROE is perceived as a reliable indicator by many investors since long and is regarded as one of the important parameter for stock selection. Many investors also believe that ROE can be used as a criterion for comparing a company with its peers. General perception is that a company with higher ROE would have a business advantage over those with low ROE. However, I do not completely subscribe to this view and believe that ROE conceals more things than it reflects.

 

Dupont’s Analysis of ROE

ROE (PAT/Equity) can be broken down into three components in Dupont’s Analysis:

ROE: (PAT/Sales)*(Sales/Assets)*(Assets/Equity)

The net result of the above equation is PAT/Equity. This breakup of ROE helps to see the sources of change in ROE over years.

The last factor of Dupont’s Analysis: Assets/Equity represents financial leverage. It means that management of any company can increase its assets by using higher amounts of debt on same levels of equity. This would result in higher ROE, which might not necessarily be due to good business performance. This might amount to manipulation of financial situation.

Whenever I have to compare a company with its peers, I compare them on sales growth, profit margins, leverage levels etc. I have found that a company, which outperforms peers on these parameters, invariably has a higher ROE than its peers. However, it is not always true the other way round. There have been companies, which show higher ROE but have not outperformed their peers on sales growth, profit margins and leverage levels in past. 

Therefore, while analyzing a company viz-a-viz its peers I prefer comparing individual business & financial parameters and ignore the packaged parameter (ROE).

Readers may see my criteria for analyzing sustainable business advantage (Moat) of any company in this article:  Business & Industry Analysis of a Company 

I would like to get your inputs about the article and your experience of using ROE as stock selection criteria.

 

P.S.

 

Share Your Inputs:

Do you rely on ROE or Earnings Yield while making investment decisions? What has been your experience with different parameters reflecting profitability? What parameters do you follow while shortlisting stocks? You can find my investment parameters here.

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