Wednesday, July 2, 2014

Investment insights: Return on Equity (ROE)


According to an article in Dr Wealth's blog, there were more than 68,000 new CDP accounts opened in the past 12 months. Apparently, the number of people who now hold securities is at an all time high of 844,000 people.While it is a fact that more and more Singaporeans are interested in making money from shares, I am not so sure whether these Singaporeans are really investors or merely speculators. Given that the Wall Street is now at record peak, many existing local stockholders' portfolio have risen in value. I reckon this must have attracted people to open trading accounts and take part in the actions as well. After all, many Singaporeans want to make money and become rich quick. But before newbie traders get carried away, it is important to build the knowledge foundation first.


Last week, one of my readers, Dexter Choo wrote in to me asking why I use Return on Equity (ROE) instead of Earning Per Share (EPS) to measure the financial health of a company. This article is written to clarify some of the strategies I use for stock analysis and hopefully readers can benefit from this sharing and went on to build their wealth.

Basically ROE reveals how much profit the management can generate with the money shareholders invested. Essentially it is a metric that measures how effective the management is in reinvesting the capital of a company. The formulas for ROE and EPS are as follows: 

Return on Equity = Net Income/Shareholder's Equity
Earning Per Share = Net Income/Number of Shares


As many readers know, shareholder equity is equal to total assets minus total liabilities. Sometimes, companies declare dividend payments and this will influence the ROE. This is because dividend payments will reduce the total shareholder equity in the balance sheet and decrease the denominator, resulting in a larger ROE. Therefore, from an investor's perspective, ROE will be a more meaningful figure compared to EPS as the former can reveal how effectively the management is deploying its retained earnings to make more money for the shareholders. The higher the ROE, the more wealth the management is creating for the company's shareholders. Generally, a company is considered a good investment if it is able to sustain a double-digit ROE for the last 5-10 years.

Another reason why I favor ROE over EPS is because the former allows me to benchmark performances of the companies in the same industry. I can compare ROE of one company to the other companies or what I can expect to earn by placing the same funds in a bank fixed deposit. EPS on the other hand, reveals how much earning per share. At best, EPS allows you to value the price of a stock but fundamentally, it doesn't allow you to determine how effective the surplus funds are deployed.

Magically yours
and the better return they can expect from their investment. A company’s ROE should be compared to that of its competitors and other companies in the same sector, whereas EPS and P/E ratios are better used as a gauge of whether the shares themselves are over or undervalued. - See more at: http://wiki.fool.com/The_Difference_Between_a_Return_on_Equity_%26_Earnings_per_Share#sthash.bE0cJD4n.dpuf

9 comments:

  1. Hi Gerald,

    "his is because dividend payments will reduce the total shareholder equity in the balance sheet and increase the denominator, resulting in a larger ROE." >> do you mean "decrease the denominator" in this case?

    Also, I prefer using ROIC as a measure because ROE tends to be distorted by high leverage.

    Regards.

    ReplyDelete
    Replies
    1. Hi Musicwhiz,

      You are right, apologies for the type mistake. I have recitfied it.

      Generally, I am not adverse to company taking on debt, as long as it is manageable and for good purposes. But you are right to point out that sometimes ROE can be manipulated by high leverage.

      So investors must dissect the balance sheet carefully.
      Thank you.

      Regards,
      Gerald

      Delete
  2. Hi Gerald

    I don't usually trust too much on ROE figures as well unless I disect them down further into Dupont ROE, where it shows the financial leverage of a company Musicwhiz brought up above.

    Taking capital structure into account, I usually prefer to use enterprise value calculation related, such as the EBITDA/EV ratio for example. EVA also provides a good gauge of whether the company is adding the right value added advantage to the company.

    ReplyDelete
    Replies
    1. Hi B,

      Well, I suppose the MBA course you are taking now is useful!

      For me, I am just an average investor and feel that ROE, couple with an analysis of the company debts is good enough for me. I focus more on the qualitative aspect rather than just the quantitative analysis.

      Nevertheless, interesting strategy you brought up. Thanks for sharing!

      Regards,
      Gerald

      Delete
  3. There is no magical Method that works for everyone. Mind and Money Management over your Method will ensure your own "safety" on the road to Financial Independence or achieving your investing goals over future market cycles of bull and bear.

    Less analyzing. More investing - Createwealth8888

    ReplyDelete
    Replies
    1. Agreed that everyone has their own style of investing. But investor must go through a thought process within himself/herself before investing, otherwise it will be no different from gambling.

      Regards,
      Gerald

      Delete
  4. Hi Gerald

    Thanks for the insight, it is a very interesting topic. I agree that ROE is definitely better than EPS. Some time earlier I also find more information from Investopedia on ROE and ROA. Below extracted from Investopedia...how ROE and ROA affects a company health. For sharing sake, please see below:

    “The big factor that separates ROE and ROA is financial debt. The balance sheet's fundamental equation shows how this is true: assets = liabilities + shareholders' equity. This equation tells us that if a company carries no debt, its shareholders' equity and its total assets will be the same. It follows then that their ROE and ROA would also be the same.

    But if that company takes on financial leverage, ROE would rise above ROA. The balance sheet equation - if expressed differently - can help us see the reason for this: shareholders' equity = assets - liabilities. By taking on debt, a company increases its assets thanks to the cash that comes in. But since equity equals assets minus total debt, a company decreases its equity by increasing debt.

    In other words, when debt increases, equity shrinks, and since equity is the ROE's denominator, ROE, in turn, gets a boost. At the same time, when a company takes on debt, the total assets - the denominator of ROA - increase. So, debt amplifies ROE in relation to ROA.

    So, be sure to look at ROA as well as ROE. They are different, but together they provide a clear picture of management's effectiveness.

    If ROA is sound and debt levels are reasonable, a strong ROE is a solid signal that managers are doing a good job of generating returns from shareholders' investments.

    ROE is certainly a "hint" that management is giving shareholders more for their money. On the other hand, if ROA is low or the company is carrying a lot of debt, a high ROE can give investors a false impression about the company's fortunes.“

    Thanks, Rolf

    ReplyDelete
    Replies
    1. Thanks Rolf for the insightful reply.
      Yes indeed, sometimes just looking at ROE superficially can misled an investor. There is why I always look at the balance sheet for debt management as well.

      Regards,
      Gerald

      Delete
  5. Equity Tips-
    Thanks for the amount of work to provide an informative article. I will certainly store it as a major point of future reference.

    ReplyDelete