Recap on valuation methodologies
Before I embarked on a discusssion on the usefulness of this ROE metric and its possible limitation, I wish to summarise my learning so far on valuing a company to know when it is wise to invest for the highest possible rate of returns. I have discussed the use of earnings yield to estimate how much yield one is getting currently by paying the current price for a stock and also estimating future yield on one's investment at current share price. Earnings yield is the reverse of P/E ratio, using earnings per share (EPS) divided by current share price and calculated as a %. I think this is a better way to determine the current yield one will be getting by investing at current share price compared to using P/E ratio. If EPS is high compared to current share price, one will ensure a high current yield when investing in a company. If the future yield can be projected with high probability based on past consistent growth in EPS of a company, one may be able to look at the future yield on one's current investment. Please refer to my earlier post "Waiting for the perfect pitch - Looking at yield on one's investment" for more details on estimating yield on investment.
The limitation of using P/E ratio is that it is difficult to determine which P/E ratio means undervalued or overvalued for a company (P/E ratio lower than 20? How about P/E ratio lower than 10?). There are many factors to consider when using P/E ratio to value a company, so it is not so easy to estimate a company's worth using P/E ratio alone. Since it is not my intention to discuss P/E ratio in details here, I will leave this for future post.
Another way of valuing a company is using a discounted cashflow (DCF) method. In using this method, one is assuming that continued ability to generate free cashflows by a company is critical for its continued survival and growth. However, as in using other valuation methods like earnings yield and P/E ratio as discussed earlier, all methods carry with them their individual limitations. DCF valuation method does not work for a company with inconsistent or negative free cashflows for most of its operating history. Also, it is not easy to estimate future growth in cashflows and the appropriate discount rate for the future cashflows to its present values. One's estimation is as much a guess compared to another's. So, to account for this uncertainty in estimating the intrinsic value per share for a company, an investor has to practise a conservative approach to invest at a margin below the estimated intrinsic value of a company called the margin of safety. Please refer to my earlier posts on "Determining intrinsic value per share of a stock" for details on using DCF to value a company.
Return on equity (ROE)
Return on equity (ROE) is a popular metric embraced by many investors and analysts for measuring the profitability of a company. How useful is it? ROE consists of three components.
The first component (Net income / Revenue) is also called 'Net Margin'. This first component can also be termed simply 'Profitability' of a company.
Net margin shows how much of each dollar of revenue a company keeps as earnings after paying all costs of doing business. A net margin (expressed in %) of 30% shows that for every dollar of revenue made, $0.30 is left over as earnings after paying off $0.70 for all costs of doing business. So, the higher the net margin (in %) the more profitable is a business.
The second component (Revenue / Assets) is also called 'Asset turnover'. This second component can also be termed simply 'Productivity' of a company.
Asset turnover measures how efficient a company is at generating revenue from each dollar of assets. A high asset turnover means the company is more productive at generating revenue from its excellent assets.
These first two components can be combined to provide the metric 'Return on assets' (ROA) as follows:-
Return on assets (%) = Net margin (%) X Asset turnover
Return on assets (ROA) shows the amount of profits a company is able to generate per dollar of assets. Companies having high ROAs are good at producing profits from their assets.
The third and last component (Assets / Shareholders' equity) is also called 'Financial leverage'. Another common term used to describe this same component is called 'Capital structure' of a company.
Financial leverage shows how much debt a company has relative to shareholders' equity. A high financial leverage ratio (e.g. significantly more than 2) may mean a company is taking on excessive debts which is risky especially if the business of the company is a cyclical or volatile one.
Usefulness of ROE
When the three components discussed above are combined together, they form the metric return on equity (ROE). The usefulness of ROE is that it shows how much returns a company can generate for its shareholders' equity (remaining interest spread among shareholders in the assets of a company after all liabilities are paid). This is shown in the reduced equation:-
ROE = Net income / Shareholders' equity
A company that shows consistently high ROE (15% or higher) over a long period of many years suggests that it is generating good returns for its shareholders. This is testimony to the company's continued profitability in its business model, economic moat and management effectiveness.
Limitation of ROE
ROE can be artificially inflated by the third component 'Financial leverage'. If the company is taking on large amounts of debts in its capital structure and having low equity base, the high financial leverage computed into the calculation of ROE can make the ROE looks too high to be true. So, an investor has to be careful when dealing with companies with high financial leverage. Investigate carefully why a company is taking on excessive amount of debts in its business. Is there justification for doing so? By being careful, it will possibly save a potential investor of unwelcomed surprises in future when a company shows up as financially unhealthy laden by excessive debts to be cleared.
Often, it is better to approach the evaluation of fundamentals of companies from a pessimistic viewpoint to dig up all possible negatives before considering the positives of the fundamentals of a company. If a company is truely an excellent one, it will stand the test of uncovering negatives about it.
Discussion points:- Return on equity (ROE) is a popular yet important metric for measuring overall profitability of a business. A consistently high ROE of 15% or more suggests that a company may have good business model, economic moat and management effectiveness.
ROE is not a magical sure-win metric. It is important to take note of the third component in this metric (financial leverage) when using ROE. A company that has high ROE but also high financial leverage may warrant further investigation to find out why a company is taking on execssive debts before putting a myopic confirmation to its profitability based on just looking at ROE alone.
Sound investing does not hinge on using only one metric (e.g. ROE) alone to judge a company's worthiness as an investment candidate. As such, ROE can be broken down into its three components to uncover further stories about a company (e..g its net margin, asset turnover and financial leverage).
Also, there are many other ways apart from using ROE to evaluate a company's fundamentals. Nevertheless, ROE continues to be a very useful metric for evaluating a company.
More on the practice of using ROE and its components in evaluating companies in my stocks portfolio in later posts.
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