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. bottom line, 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 a 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 Company” that 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 an 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 the 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 the intended purchaser.
We witnessed earlier that by the 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 the market ignores company A (having a lower ROE of 10%) and reduces the 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 a perceived average value at a discount.
As the 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 a significant discount, then she could get 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 a fair price or a fair company at a 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 significantly discounted price would ensure that the investor gets a very high effective profitability from her investment and her portfolio can experience a 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 the acquisition price of an existing investor or with current market price (CMP) for a potential investor.
EPS / (CMP or Acquisition cost of share) = Effective Profitability Ratio
The Effective Profitability Ratio is a better and meaningful parameter for any investor to consider before making an investment in the stock of any company.
The 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 an 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: Dupont’s Analysis of ROE
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 parameters for stock selection. Many investors also believe that ROE can be used as a criterion for comparing a company with its peers. The 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.
ROE (PAT/Equity) can be broken down into three components in Dupont’s Analysis:
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 the management of any company can increase its assets by using higher amounts of debt on the 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
Readers’ Queries about our views on ROE
Hello Dr Vijay,
I am an American investor and I do use return on equity (ROE) in my inputs, although I use it in the same way you do. i.e. if I find a company that earns roughly 10% ROE but is trading at 0.5BV, then as an investor I am earning a 20% return.
However, I would add that I believe ROE is very important in the long-run. If a company retains all its earnings and earns 20% ROE, that company will be worth much more than one that earns 10% ROE.
For example, we have one company that earns 10% ROE and trades at a book value of 1 both when you purchase it and when you sell it, after 10 years, this hypothetical company would be worth 2.59. Your return is over 150%.
Now, we have another company that earns 20% ROE and trades at 4x book value of 1 but then declines to a more “fair value” of 2.5x book value over ten years. So book value grows to become 6.19, but since you paid 4x book value, your cost is 4. So your return is only 50%.
Now if you take these two same companies but only change the time period to twenty years you get a different result. The first company’s book value grows to 6.7 from your purchase price of 1, a 570% return! The second company grows book value to 38.3 from a purchase price of 4 (4x book value), for a return of 9.6x your money or 860%.
Your criticism may well be that 20 years is a long time for most people to wait, but this is what Buffett is talking about when he says time is the friend of the wonderful business.
Thanks for providing your inputs!
We appreciate the time & effort put in by you to express your opinion, which is useful for both the author and the readers of the website.
Your calculation and depiction of different scenarios are insightful. 20 years should be the time horizon for investors and therefore, is not a very long term horizon.
As mentioned in the article, we advise readers to focus more on individual assessment parameters of any company instead of composite parameters like ROE (citing the example of DuPont’s analysis). We have noticed that whenever, we have found a fundamentally strong company with good business growth rate and handsome profitability margins, which is conservatively funded, always has a good ROE. Therefore, we advise readers to focus on each parameter separately. Looking only at one composite parameter like ROE many times hides some important aspects of assessment like leverage.
You have correctly identified that a company with good business performance is bound to reward shareholders. However, the more an investor pays for a company in terms of the initial purchase price, the longer she has to wait to realize a return.
Thanks once again for your inputs.
All the best for your investing journey!
ROE & P/B ratio as interlinked valuation parameters
Great viewpoint and also completely different from the general perception.
However, I would tend to diverge from this view, because let’s suppose there are two companies A and B earning same profit after tax (PAT) ₹100/year and their book values are ₹1,000 and ₹2,000 respectively (hence ROE is 10 and 5 respectively). Now, if we buy company A at 2 times book value and company B at 1x book value, ideally, we bought them at the same valuation as per your view.
But shouldn’t company A get more premium compared to B since it can generate the same profits on fewer assets compared to B. Also, it shows that the capex requirement of A is less and hence, it should command a higher premium. So I believe company A in this case is cheap compared to B.
Kindly provide your views on this.
It’s interesting to get your queries and answering to them. I appreciate the effort you put in while going through the articles and providing your inputs for the benefit of the author and readers of www.drvijaymalik.com
Company A is definitely good at P/B of 1. It might still be good at P/B of 2. But there would be a P/B level at which it would not remain attractive. This level can be P/B of 3 or 5 or 10. The main point here is that ROE alone does not give the true picture. The purchase price will always be a factor to determine its usefulness for any investor.
You would appreciate that in markets different people interpret the same set of data with different conclusions. This difference in perception creates the market and generates trade.
Dr Vijay Malik
Return on Equity: Business Parameter vs. Valuation Parameter
- The purpose of the ROE metric is not to measure the “stock market returns”. It’s rather a business return metric, which is completely different from earnings yield.
- ROE, when decomposed, has three components, Profitability, Asset Turnover and Leverage. You are right the Leverage component can be manipulated. But why would management do that?
Thanks for your inputs!
You are right that ROE is more suitable as a business evaluation parameter.
I believe that solely chasing high ROE companies without looking at the price one pays for them, might not suit the investors. Warren Buffett has highlighted it time and again to his shareholders. He says this in the latest (2014) letter:
“Of course, a business with terrific economics can be a bad investment if it is bought for too high a price.”
“This cheery prediction comes, however, with an important caution: If an investor’s entry point into Berkshire stock is unusually high – at a price, say, approaching double book value, which Berkshire shares have occasionally reached – it may well be many years before the investor can realize a profit. In other words, a sound investment can morph into a rash speculation if it is bought at an elevated price. Berkshire is not exempt from this truth.”
You may read more about my take on Warren Buffett’s latest letter at:
Management might have more than one reason to manipulate ROE. Keeping ESOPs “in the money” can be one of them.
Dr Vijay Malik
I am new to this forum and not an expert on finance but I have been investing since the year 2000. I feel that in this article you are trying to relate RoE with the valuation, which is not correct.
RoE represents the efficiency of a company in using its resources. It has nothing to do with CMP. RoE should never be used as a valuation tool. We have to focus on other tools such as sales growth, NPM, debt/equity etc. In fact, RoCE takes care of the debt part and hence RoE and RoCE can be used together. For valuation, we can use P/E or its inverse earnings yield, PEG, Rate of return
Thanks for your feedback and inputs!
You are right that by definition, ROE measures business performance. However, the article aims to highlight that focusing on ROE alone without factoring in the price that an investor pays to buy that ROE, should not be the preferred approach.
The article uses the concept of Price to Book value (P/B ratio) to substantiate the concept of Effective Profitability Ratio. Regarding other parameters for valuation analysis, including the ones mentioned by you, an investor may read the following article:
Dr Vijay Malik
What is the role of the weighted average cost of capital (WACC) & return on capital employed (ROCE) in our stock analysis
My viewpoint is that there are 2 critical factors: Weighted average cost of capital (WACC) & return on capital employed (ROCE), which need evaluation for any and every company and all other factors will fall into place.
Why don’t we focus on these two factors only?
Thanks for writing to us!
We do not use either the weighted average cost of capital (WACC) or the return on capital employed (ROCE) in our stock analysis. This is because:
1) One of the key components of WACC, the cost of equity, is a highly subjectively estimated figure unlike the other component, the cost of debt. We are not able to put any precise estimate to the cost of equity of any company, which can be used in a mathematical formula as is prevalent to calculate WACC. We are only able to opine that the cost of equity for a well-managed fundamentally sound company is higher than a poorly managed company facing stress. Beyond that, we are not able to have an opinion on the cost of equity and hence on WACC.
2) We do not use composite ratios like ROE & ROCE as a parameter in our stock analysis. This is because; these ratios usually represent the compound impact of individual components ratios like profitability margin, asset turnover and leverage. We prefer to analyse each of these component ratios individually in our analysis. To elucidate further, we prefer companies with high profitability margin, high asset turnover but with low leverage. Therefore, if there are two companies with equal profitability margin and equal asset turnover and the ROE/ROCE of one company is higher than the other company only due to the higher leverage on its books, then we would prefer the company with lower leverage and in turn the one with lower ROE/ROCE.
Hope it helps you understand our views about WACC and ROE/ROCE.
All the best for your investing journey!
Dr Vijay Malik
I would like to get your inputs about the article and your experience of using ROE as stock selection criteria.
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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.