The 6 dangers of Return On Equity (example: Dino Polska)
In the past, we’ve uncovered the mysteries of the P/E multiple and the ROIC ratio. There is more than meets the eye in both ratios.
When looking at our 100-bagger checklist, we haven’t discussed Return on Equity (ROE) yet.
This article describes the pitfalls and traps related to the return on equity ratio.
Let’s dig in.
A short introduction to ROE
Return on equity is a measure of the net profits that are generated by a firm based on each dollar of equity capital raised from investors. We’ll take a look at the financial statements of Dino Polska (Ticker: DNP.WA)
The net profits are the net income from the income statement.
The equity capital is the average book value of the total shareholder’s capital.
We can find the data from the balance sheet on Yahoo Finance:
Or directly from the 2022 annual report:
The average equity book value is then the average of these 2 values which gives us 3,636 million Polish zloty.
Dino has an ROE of 1,132/3,636 = 31%
Dino’s management can convert its equity capital into net income at a high rate.
Does ROE matter?
The book, What Works on Wall Street, has a whole chapter dedicated to the impact of the level of ROE. It looks at stock performance over the period from 1963 to 2009.
Then they:
Compare the company's performance with the highest ROE to the overall market
Divide the companies into 10 deciles from lowest to highest ROE and see if there is a difference in performance
The table below shows what the result would be at the end of December 2009 if you had invested 10,000 dollars in the highest ROE and lowest ROE companies in January 1963 with annual rebalancing:
You can see what a difference of 1% in CAGR does over an almost 50-year period when comparing the high ROE companies to the overall stock market. But the most important conclusion of this table is to avoid low ROE companies. They perform a lot worse and have more volatility.
We can also take a look at the performance over different holding periods. The table below compares the companies with the lowest ROE to the highest ROE in the overall stock market:
This means that in the short term, the low ROE companies are much more volatile and lead to lower minimum and maximum returns compared to high ROE companies or the overall market. But more interesting is that in the longer term, the performance between high ROE companies and the overall market sits in the same range. But, the reason to avoid low ROE companies is to avoid more downward loss.
To emphasize this, we can look at the company universe cut into 10 deciles with 1 being the companies with the highest ROE and 10 being the lowest:
Low ROEs will lead to underperformance. High ROEs can lead to better performance, but only in the very long term.
What is a good ROE?
In the previous paragraph, we didn’t give any absolute values for what a good ROE is. The simple answer would be, as high as possible. Our 100-bagger checklist considers an ROE to be good above 15% and exceptional above 25%.
If in the long term, you own a company that compounds ROE at 15%, then over that period you will get something close to that return percentage. But as always in investing, the correct answer is, it depends. Investing is a relative game.
ROE differs from industry to industry. On the surface, a company compounding at an ROE of 15% might look good, but maybe the best in class in the industry have much higher returns.
Professor Damodaran has interesting datasets we can look at to get an idea about what the typical ROE looks like for a specific industry.
Because we used Dino Polska as an example, let’s take a look at what the ROE looks like (globally) for the retail/grocery industry.
This immediately reveals that on average, the ROE in the market is quite high with drops towards 15% only in 2019 and 2021. DINO does slightly better and more importantly, has a stable ROE.
The average can give us a skewed view of what is happening. Here’s some data from gurufocus.com when looking at the industry distribution:
This is a picture of the consumer defensive industry. There are 302 companies in this sample. Dino is located in the top 40 or top 13% of companies in that industry.
US Industries with the lowest ROEs
Based on data from Professor Damodaran, we can take a look at the industries with the worst ROE over the last decade. The table below shows the 3 industries from 2013 to 2022 with the lowest Return on Equity.
The first 2 aren’t surprising.
US Industries with the highest ROEs
And who are the industries that had the highest ROE over the last decade?
Most people know these specific companies for the industries, so it may not be that surprising. You can find the full list of companies that are included in these industries here.
The dangers of using ROE
Compared to a measure like ROIC, ROE is easier to manipulate.
The impact of debt
If a company takes on more debt and increases its financial leverage, this can reduce shareholders' equity which leads to a higher return on equity. This means that when looking at ROE alone, you’re ignoring the risk profile of the company.
A 3 step DuPont analysis lets us divide the ROE into its constituting parts, to get more visibility on what is happening.
We can do this for Dino like this:
We multiply both terms of the ROE ratio by sales and total assets. Then we get:
(Net Income / Sales) X (Sales / Total Assets) X (Total Assets / Shareholders Equity)
This is the same as:
Net margin X Asset Turnover X Equity Multiplier
The equity multiplier gives you an idea of the degree of leverage. If the company has no debt, then the multiplier will be equal to 1.
For Dino Polska, we get:
Net Margin = 6.1%
Asset Turnover = 2.9
Equity Multiplier = 1.9
So for Dino, almost 50% is debt and 50% is equity.
The impact of share buybacks
When a company decides to buy back shares, the equity part of the balance sheet is reduced which leads to an increased ROE. This in itself is not a bad thing, but it’s important to understand where the performance comes from when comparing companies.
R&D
Because ROE is based on net income, several accounting principles can be used to deform the bottom line and as a result influence ROE.
Research and Development costs are one example. Based on the accounting practices, there are 2 possibilities:
They are treated as expenses in the year that the costs are spent -> The value of the assets created by R&D will not show up on the balance sheet
They are viewed as capex costs, where for example the value is amortized over 5 years
If R&D is treated as CAPEX then:
Operating income will increase
Equity value will increase as R&D appears with a value on the balance sheet
You can find an example with a calculation here.
Which industries have the biggest differences between ROE and ROE adjusted for R&D?
It’s important to make sure that for these types of industries when comparing companies, they are using similar accounting standards. Or else, you may be comparing apples to oranges.
The impact of cyclicality
Industries like automobiles or construction can see a sharp upswing and consequently downturn due to their cyclicality. This will inflate and then deflate the ROE of these companies. It is important to look at the history, recognize the cyclicality, and normalize the ROE over a certain period to better compare different companies.
One-off gains or losses
Companies, due to the sales or acquisition of certain assets, can make a one-off profit or loss on their income statement. This will momentarily change the return on equity. Taking into account and correcting for these profits and losses will allow you to normalize earnings and get a return on equity that is comparable.
Conclusion
From the Millenial Investing podcast with Kylie Grieve and Jason Donville:
The challenge though that’s happened in my investing career is that balance sheets are getting distorted by a lot of different things. This means calculating the true return on equity of a business, which can still be done, is not a five-minute exercise with a calculator and the financial statements.
You would have to go back over the, almost the history of the company and re-add everything in and all that kind of stuff. We’re increasingly looking at things like the relationship between margins, sales growth, that kind of stuff and saying, If this company had a normalized balance sheet, it would probably be a 25 percent ROE company.
- Jason Donville
This more or less sums it up. ROE is an easy and useful metric, but one must be mindful of the dangers it represents.
A low asset, 100% equity financed business, can give a true value of the ROE and efficiency of the business. But if a business is levered, with several changes in the past on the assets of the balance sheet, impacted by cyclicality, be mindful and do the work to uncover the true ROE.
In summary, Return On Equity is a useful metric but,
Is impacted by the cyclicality of the industry
Ignores debt and the risk profile of the company
Needs to be normalized for one-off gains or losses
Is industry specific: Do not compare across industries
Is impacted by historical changes on the balance sheet
Can change based on accounting standards used (R&D)
The bottom line: Always use ROE together with other financial metrics, like ROIC or Free Cash Flow.
Further reading:
Check out the ROE reporter from Donville Kent Asset Management which provides interesting insights into how they use ROE in their investing strategy.
Listen to the Millenial Investing Podcast episode if you prefer audio
Pure 101 Finance on ROE