Imagine you are overweight by 30kgs and need to shed those extra pounds as soon as possible.
The very first instinct of a newbie or an experienced person would be to hit the gym or start work out as soon as possible.
That said, we also know that any form of workout forms only a maximum of 20% of the total weight loss program.
What about the remaining 80%?
Diet is the most crucial part of such a regime.
Just like diet is for weight loss training in the same way ‘Return on Investment’ is for Investors.
Here’s an insightful post for new investors or a continuous reminder for more experienced investors.
If the calorie counting number is for weight loss, for a company, the most important number is return-on-equity.
Let’s keep aside heavy technical like jargons head-and-shoulders, forget bear traps and double bottoms, forget volume, forget stochastics.
Return-on-equity through numbers conveys how well a company is performing. It’s the best measure of efficiency.
In short, ROE tells us how much we get for how much we got.
In a bit technical language, Return on Equity is how much profit a company generates when compared to shareholder equity.
ROE is so special because it acts as a tool to conclude about a company irrespective of the price of the stock.
It emphasises on company’s performance and not the stock’s performance.
ROE = Company’s Profit / Equity
Net Income is the profit that the company generates after expenses, but before dividends paid out to common shareholders.
Shareholder equity is calculated by subtracting the liabilities of a company from its assets.
How to evaluate a good company?
Understanding ROE with numbers
In the above example, for a given year we have considered 3 different cases.
In the first case, we see that company one is fully funded by itself and has an ROE of 20%.
In the third company, debt is higher than the other 2 and so is the ROE.
While evaluating a company based on its ROE, debt structure must be given special importance.
If ROE rises with rising in debt- this isn’t a good indicator. It is because higher debt signifies high interest costs.
Thus, to infer, the ROE of a company is considered to be of good quality only when it rises consistently while the overall debt is either zero or remains the same or decreases.
The ideal ROE should be around 17-18%.
Key factors to watch for in looking at ROE
Debt on the balance sheet- A honest management will always be debt cladded business, which is seen from empirical trends. However, this needs to be cross-checked on a case-to-case basis.
It is important to find out how a large ROE is generated- is it by excessively leveraging the balance sheet.
Generation of a high ROE- Companies with shady management are unlikely to report a consistently high ROE over a long time.
Why is it important?
It helps us analyse how the business is growing.
If there is no increment in the debt or assets from the year before and profits increase, then ROE will also increase. This would mean that the company is using those same resources (assets) more efficiently than before and such companies show the good sign for growth and hence beneficial to investment.
So, it’s essential for us to be sure that we are comparing the return on equity of companies with their peers.
Not to forget the drawbacks and risks associated.
Imagine a company that had the same assets and the same profits as the year before. The only thing that has changed is that the company has taken on more debt.
It is the same as burning calories without a diet plan.
The formula for equity is assets minus debt.
If a company takes on more debt, equity shrinks.
Shrinking equity leads to profit stagnation, thus making the ROE appear higher.
In this case, this is not a real improvement in efficiency, it’s merely borrowing money with no growth in profitability and this is a bad thing.
In his 1977 letter to shareholder, Warren Buffet specifically wrote investors to beware of companies with a high return on equity if they also have high debt to equity ratios.
This adds up perfectly because that high debt to equity ratios implies that ROE is likely higher for more debt.
ROE is a good test to see if the company is genuinely growing at a respectable rate.
Looking closely at ROE will give us a good view of how the company is genuinely performing despite how the stock’s performance in the market.
One should try to focus on the long term and not the everyday ripples of a rather irrational stock market.
One reason for which ROE is like the Pole star for sailors/investors in the market is that it works for every company.