Why ROE is the most important metric
Consider the following two lemonade stands:
Stand 1 required $100 from the owners to set up; in the first year of business the stand made $50.
Stand 2 only required $50 from the owners to set up; in the first year the stand made $30.
Which stand is better?
It all comes down to return on equity. Stand 1 has a return on equity of 50%, and stand 2 has an ROE of 60%. It’s obvious that we would rather own stand 2, because it was cheaper to establish, and makes a greater percentage of revenue on its base than stand 1.
Very often you will see companies publish results showing strong profit growth. However, profit growth is almost an irrelevant factor; we need to determine if the business is increasing profit on an unchanged capital base, or if they have been increasing debt and equity capital at a disproportional rate compared to such profit growth. Here’s an example.
A business has grown profits 20% annually for the last 5 years. In year 1 they had profits of $100, which means in year 5 they had profits of $250 ($248.8 to be exact).
On face value this looks fantastic. However upon deep diving into their annual report, we see that they have raised significant amounts of share capital (equity) since year 1.
In year 1 the business had an equity base of $500. Each year, the business raised a further $200 of share capital. In year 5 the business had an equity base of $1,500.
In year 1, the business made $100 from the $500 of equity posted by the owners, a 20% return on equity. In year 5, the business made $250 of $1,500, a return on equity of 16.7%.
We can see from the above that return on equity is more important than headline profit growth, because over time if the business continues to earn less on it’s capital base, it will eventually become an untenable investment.
For a business like the above, it’s likely they are very capital intensive and will need to continue raising capital to fund the 20% profit growth. Eventually the return on invested capital will be diluted so much so, that investors will realise this and run for the hills.
High returns on equity are achieved by business’s with barriers to entry.
Companies that are able to sustained high ROE’s are always superior investments over time, they have characteristics that protect their earnings power from new competitors wanting to enter the market.
Something to watch out for
Highly leveraged companies (debt increases ROE). When your looking at profit growth and the equity capital base growth of a company over time, also pay attention to debt growth over time. If the company has been primarily funding growth through debt, this a red flag. Debt is not as expensive as equity (given low interest rates), however added debt still dilutes shareholder returns, and increases the risk profile of the business.