Is Return on Equity (ROE) the best metric for making investment decisions?
That’s the question I want to address here.
And in the spirit of maximising your Return on Time (ROT), I’ll get to the point without delay.
Why ROE is a great investment metric
Our editorial director Greg Canavan has a great book all about valuation called You, Your Brain & the Stock Market.
In it, Greg emphasised the importance of ROE. Here’s a choice snippet, but I encourage you to read the whole book if you can, it’s a great read:
‘And as an all-round indicator of a company’s competitive position and management capability, ROE is one of the best indicators there is.
‘To get a better idea of how the companies are really performing, you need to look at their return on equity.’
The importance of ROE is undisputed.
One of the best-selling investment books centred its thesis on buying cheap stocks generating high returns on capital.
You may even have that book on your shelf somewhere, Joel Greenblatt’s The Little Book That Still Beats the Stock Market.
In it, Greenblatt banged on about the counterintuitive ease of his ‘low P/E, high ROE’ formula:
‘If you just stick to buying good companies (ones that have a high return on capital) and to buying those companies only at bargain prices (at prices that give you a high earnings yield), you can end up systematically buying many of the good companies that crazy Mr. Market has decided to literally give away. You can achieve investment returns that beat the pants off even the best investment professionals (including the smartest professional I know). You can beat the returns of top-notch professors and outperform every academic study ever done. In fact, you can more than double the annual returns of the stock market averages!’
Returns that beat the pants off the best investment pros?
Quite the claim, Mr Greenblatt!
He did cite back-tested data corroborating his ‘magic formula’:
‘Over a 17-year period from 1988 to 2004, owning a portfolio of approximately 30 stocks that had the best combination of a high return on capital and a high earnings yield would have returned approximately 30.8 percent per year. Investing at that rate for 17 years, $11,000 would have turned into well over $1 million.
‘During those same 17 years, the overall market averaged a return of about 12.3 percent per year. At that rate, $11,000 would still have turned into an impressive $79,000. While that’s certainly a lot, $1 million is more!’
The logic of prioritising businesses that can reinvest capital at high rates is ironclad.
But is there more to ROE as a financial metric?
Economic value added and total returns
Does return on equity have shortcomings? Can we use the metric without reservations?
You can probably guess my answer.
No. ROE has its limits as a final arbiter of stock success. Investing is not that easy.
To understand why ROE is sometimes not enough as a comprehensive measure, we need to discuss the nature of business itself.
What does an enterprise seek to do?
Add value.
Stephen Penman put it vividly by noting business is all about arbitrage (emphasis added):
‘Businesses are actually in the business of arbitrage. A business is a matter of trading in input markets (for assets, materials, labour, and so on) and in output markets (with customers). Business models are conceived to sell high (to customers in output markets) and buy low (from suppliers in input markets), adding value (profits) from the spread. In short, entrepreneurs arbitrage input and output markets.’
Economists, prone to adding a patina of complexity on common concepts, call this economic value added.
British economist John Kay explained this in Foundations of Corporate Success (emphasis added):
‘What is corporate success, and how is it measured?
‘Sometimes performance is assessed by reference to rate of return. This can be measured as return on equity, on investment, or on sales. And sometimes success is measured by growth…
‘All of these are aspects of successful performance. But I argue…the key measure of corporate success is added value. Added value is the difference between the value of a firm’s output and the cost of the firm’s inputs. In this specific sense, adding value is both the proper motivation of corporate activity and the measure of its achievement.
‘What underpins the success of firms…is their ability to add value to the inputs they use. It is the difference between the market value of its output and the cost of its inputs.’
Does a company with a ROE of 50% add more value than a company with a ROE of 15%?
Not necessarily.
That’s the issue with metrics — they are relative.
In absolute terms, the picture may change.
Kay used British supermarkets to illustrate. In the 1990s, Sainsbury’s and Tesco had lower returns on equity than Kwik Save or Argyll.
Did this make them less attractive investments?
No.
According to Kay, the pair’s lower ROE is ‘more a warning that these are unreliable indicators than a comment on the performance of the companies’:
‘The return on capital is simply a ratio of two numbers, not a guide to what you will earn by investing more in the business, and Tesco and Sainsbury’s have been using their capital as effectively as they can.
‘It is worth their while to invest in stores so long as they can earn more from building stores than the 10% or so return on capital they would have got from the bank.’
The last point is crucial and is the basis for much of valuation theory, from McKinsey to Damodaran.
The key to adding value — corporate and shareholder — is growing only when you can invest at returns above your cost of capital or opportunity cost.
Greg made the same point in his book, too, by referring to an investor’s required rate of return:
‘A good rule of thumb you can use is that if a company has a ROE above the required rate of return, it is creating value. If ROE is below the required return, it is destroying value.’
Continuing Kay’s example, it was worth it for Sainsbury’s and Tesco to invest in more stores because they still came out ahead after accounting for their cost of capital.
This ‘reinvestment has the effect of driving down their return on capital but it makes them, taken as a whole, more profitable businesses not less’.
But here’s the final puzzle piece to adding value, one that recognises the importance of considering absolute returns.
Economic profit — or value added — is the spread between return on equity and cost of capital, multiplied by the amount of invested capital.
As my edition of McKinsey’s Valuation puts it:
‘The objective is to maximise economic profit over the long term, not ROIC [or ROE]. Consider an extreme example: most investors would prefer to earn a 20% return on $1 million of capital, rather than a 50% return on $1,000 of capital, even though the rate of return on the smaller capital is higher.’
ROE is a valuable metric.
When used in conjunction with everything else we’ve discussed here, it is more valuable still.
Regards,
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Kiryll Prakapenka,
Editor, Money Morning
