It's not Caviar.

Return on Equity (ROE)


Let me start with a note of explanation. I am sure that to many of you these simplistic explanations of mine of topics like PE and ROE are "old hat". To you, I apologize - you have my permission to skip these posts. However, I would like to think that there may be some people out there who might gain something from my ramblings. I personally enjoy thinking about these things (writing helps me think) and attempting to reduce them to relatively simple and understandable descriptions. 


Ok.


Return on Equity is ... well ... the return on equity that a company makes. 


To make any sense of ROE we need first to understand what equity is. To an accountant this will come as second nature. Even to somebody that understands double entry bookkeeping (me) it is not too hard to understand. (Probably the most useful thing that I know, to assist me in my investing activities, is an understanding of double entry bookkeeping - keep that in mind if you find yourself looking for something useful to learn).


Equity is what a company "owes" you, the investor. It is the sum of all the money that you have invested in* the company, plus all the profits that the company has ever earned, less all the losses that the company has ever made, less all the money that you have taken out of the company (usually as dividends). 


* (did you notice the asterisk). There is a very important point here. We have to make a very clear distinction between the financial operations of the company and the way we invest in the company through the share market. It's really, really important that we have this distinction very clear in our minds - not only for an understanding of equity but for an understanding of all aspects of our investment. Let me explain a little further. When you buy shares on the stock market you are not buying them from the Company, you are buying them from another investor. The money that you pay does not go to the company. The price you pay for those shares is entirely between you and the seller - it does not change anything at all about the finances of the company itself. 


So, we need to expand a little on the statement "...the sum of all money that you have invested in the company". The "money" that we are talking about here is not the money that you have paid for the shares but the investment in equity that the seller is selling you. In fact, in most cases, the equity that you are buying will be a lot less than the share price that you are paying.


For example ... let's just pick a company at random .... hmmmm .... Cellestis. As at 30th December 2009 the Equity per share was 24c but the Share Price was $3.27.


(end of asterisk bit)


So, now we (hopefully) know what equity is we can easily understand what Return on Equity (ROE) is. It is just the Company Earnings / Equity.


But what use is it?


That's the important question.


It's not unusual to see a list of Companies presented with their respective ROEs. To me, such a list is easily misunderstood to provide some sort of numerical comparison between the Companies. Surely a company with an ROE of 25% is better than one with an ROE of 15%? 


'Aint necessarily so.


Even very simplistically we can see that it is not possible to compare two possible investments based purely on their ROE. It would depend upon the price you are paying for the equity. Of course you could factor the share price in but it achieves little - it actually just takes you back to a PE value.


There is more, much more to it.


A very common mention of ROE is in the description "ROE is a measure of how effectively a Company is using it's assets* to generate income". That is true, as far as it goes.


*(another asterisk) On a balance sheet, equity = net assets.


That fact alone may be useful in comparing two similar companies. It is less useful when comparing quite different companies (An earthmoving company probably needs more assets to generate it's income than a software company). It's almost a measure of efficiency. If two companies, Company A and Company B are operating in similar businesses but Company A has a higher ROE then, on the surface, it is using it's assets more effectively. Why would this be so? Many reasons. Maybe Company B owns a $5m office building whereas Company A has used the $5m to buy a few more bulldozers and rents an office. Stuff to look for.


Here's the really interesting part. Marginal ROE.


What we are talking about here is the ability of the company to use additional equity to generate additional profits. Specifically, can they maintain (or improve) their existing ROE with additional equity. After all, we would like to see the Company we have invested in grow over time.


How do we establish this? Firstly we just apply some common sense. If the Company is operating a fruit juice shop in three shopping centres, each of which is generating good profits and a good ROE then we might assume that they can use some additional equity to open more shops in more shopping centres, each operating just as successfully as the first three. Until they have a shop in every shopping centre (all else being equal) this can continue. On the other hand, if the company has the sole supply contract for facemasks to Government Hospitals, it may not be able to use any additional equity effectively. There are many permutations - some companies can use additional equity to improve ROE, others can use equity to grow the business but at a lower ROE and others may not have a use for additional equity at all.


Secondly, if the company has been operating for some time we can look at it's historical use of additional equity.   


How does a company get additional equity? Three main ways.

1. Borrowing.
2. Raising additional capital from the market (ie issue more shares).
3. Retaining profits.

Borrowing can be really good for a Company. If the Company can receive a return on the borrowed funds that is greater than the cost (interest) of the borrowed funds then they are ahead (obviously). However, this needs to be factored into the above considerations. Note that borrowing money does not change the equity at all. So, if a company has an ROE of 20%, a Marginal ROE of 15% , interest cost of 8% and equity of $10m it could borrow $10m and the ROE would jump to 27%. (That's why raw ROE figures are only a starting point for analysis of a company). Go on - work it out for yourself - I know you can.

Alternatively, the Company could issue $10m worth of new shares (increasing the equity to $20m). In this case the ROE would fall to 13.5%. 

These are extreme examples. There are many other considerations too. Not the least being your (the investor) return on the new capital that you contribute. 

The third way for a Company to increase equity is by retaining profits. That is, by not paying out 100% of the profits in dividends. As an investor, you should apply the same considerations about ROE here as you would above. That is, is the Company using your money (the part of the earnings that they keep) effectively. If all they can think to do with the retained earnings is to put it in a bank account earning interest then it would be much better for you if they gave it to you as a dividend - if you are a good investor you should be able to do better than bank interest with the money.


However, here's something interesting.


Way back up there we noted that most often, on the share market, we don't get to buy equity at it's book value. (In the case of Cellestis we had to pay $3.27 for 24c worth of equity). That probably made you a bit jealous of the person that sold you the shares - if they were the person who bought them in the float). You, too, can buy equity at par value. Look at the following.


Take a fictional Company with the following statistics:

• Equity per share $1.00
• ROE 20%
• Marginal ROE 20%
• Share price $2.00

You might be quite happy to buy this share. After all the PE is 10. 

Let's look at what happens with the earnings. The earnings are 20c per share. The company decides to pay out 50% of the earnings as a dividend - 10c. The other 10c is retained - it adds to your equity. Now your equity is $1.10. next year because the Marginal ROE is 20%, the earnings will be 22c. Your PE has come down to 9.1. Brilliant. That's because you got to buy equity at it's real value - not the "inflated" price that you would have to pay on the share market. Of course it's likely that the market will now reprice the shares at 10 times earnings - $2.20. The 10c retained earnings that you "reinvested" is now worth 20c. Even more brilliant. 


I don't know about you, but I'd be begging the company to not pay me any dividend.

Just as with a PE, the ROE is a useful metric - it just needs to be clearly understood.