Why You Shouldn’t Obsesses Over Return On Equity When Investing

Return on Equity (ROE) is one the favourite metrics used by investors. In fact, if you are introduced to investing via a course or a book, it is probably one of the first things you learn.

Most notably, Warren Buffet has mentioned that he considers ROE important (and as always, anything he utters is blown out of proportion by the media). But there are good reasons not to consider ROE the be-all and end-all when it comes to picking your investments:

What is ROE?

ROE is, simply put, net income divided by shareholder equity. This indicates how profitable a business is, by determining how much you get out of every dollar put into it.

A business with a net income of $270 million, and shareholder equity of $800 million, we’d be looking at a ROE of 33 per cent. Many investors would say that’s a pretty good deal (it’s been repeated, for a long time, that ROE of 15 to 20 per cent is good).

But while there’s no denying that ROE is a useful indicator, it tends to be exaggerated. Like the Price to Earnings (P/E) ratio, it’s often mistaken as a “golden rule” for new investors to base big decisions off, without reading things in context.

There are a number of companies out there with sky high ROEs, that might take in unsuspecting new investors. As an example, let’s look at Campbell Soup Co. (CPB).

In May this year, Food Business News reported that Campbell Soup was still struggling to gain momentum. For those of you not familiar with this industry, canned food products have struggled over the past five years, largely due to rising health concerns about processed foods.

During Q3 2015, earnings for Campbell Soup were flat. Soup sales in the US fell 10 per cent that quarter, and the WSJ reported that their share value was down by the biggest amount in more than two years.

But if you look at ROE, Campbell Soup didn’t look anything like a company that would struggle in 2015. Step back a year to 2014, and you would have seen Campbell Soup has a ROE of 56.86 per cent, way above the industry median of 8.34 per cent.

Clearly, ROE wasn’t giving the full picture behind the company’s situation.

Why can’t we rely too much on the ROE?

ROE, while important, is a metric that is fairly easily to manipulate.

The key issue is that ROE can appear to rise in one of two ways: you can drive it up by genuinely making more money, or you can make it rise by lowering shareholder equity. For example:

Say company X has a net income of $17 million, a dismal figure considering its shareholder equity of $370 million. That’s an ROE of just 4.59 per cent.

The company then goes on an aggressive share buyback programme, thus lowering the amount of shareholder equity. It manages to get shareholder equity down to about $270 million, but it’s net income doesn’t change at all.

By way of mathematics, company X now has a ROE of ($17 million / $270 million x 100) = 6.29 per cent.

The company has – superficially – appeared to improve its profitability by 1.7 per cent, without adding so much as a dollar to its net income.

A company doesn’t just have to buy back its shares. It can also use leveraging as a way to raise ROE. Shareholder equity the difference between total assets, minus total liabilities. All a company has to do is borrow aggressively to raise its liabilities, and its ROE will rise if it just maintains net income.

In the above example, company X could simply have borrowed $100 million instead of buying back $100 million of its own shares. Its ROE would still have risen in the same way. This is why it’s imperative for investors to check the Debt to Equity (D/E) ratio of a company as well – indicators have to be read in context of each other.

How ROE is an issue outside of your portfolio

Outside of picking our own investments, ROE has come to the attention of a growing – and vocal – group of critics who feel the flawed perception of this metric could harm the economy.

Economist John Kay famously went after Deutsche Bank by saying:

“Even as the thinly capitalised Deutsche Bank was benefiting from state guarantees of its liabilities, it was buying back its own shares to reduce its capital base. And whatever return on equity was claimed by the financial officers of Deutsche Bank, the shareholder returns told a different, and more enlightening, story: the average annual total return on its shares (in US dollars with dividends re-invested) over the period May 2002 to May 2012 (Ackermann’s tenure as chief executive of the bank) was around minus 2 per cent. RoE is an inappropriate performance metric for any company, but especially for a bank, and it is bizarre that its use should have been championed by people who profess particular expertise in financial and risk management.”

We won’t go so far as to claim it’s inappropriate for any company; like any other metric it has its place and use. But it’s certainly true that, given how many investors like to over-emphasise it, it can result in some unhealthy incentives.

We dread the thought of CEOs executing share buy backs or leveraging heavily, just to raise ROE and give the impression of good performance. Perhaps it’s time everyone – investors or otherwise – ensured that such gestures don’t really fool us. We don’t need another wide scale crisis.

This article was contributed by SingSaver.com.sg, Singapore’s #1 personal finance comparison website for credit cards and personal loans.

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