The Trap of the Return on Equity of a Company
When I am investing in the stock market, I am trying to find businesses which have a very high return on equity.
The return on equity is basically the money that I am getting, relative to the money I am investing.
Higher the return on equity, better is the company.
However, there are four points I want to discuss about return on equity, because, return on equity sometimes, can be misleading.
1) High debt
If the company has high debt on the balance sheet, it will show a small equity.
If the company makes a large profit due to all this capital invested, that profit goes to the numerator and the equity remains in the denominator.
This artificially increases the RoE [Return on Equity].
Just because the company has got a high RoE, does not mean, it's a great company.
The company has actually raised money by selling bonds, and the company has to eventually repay back those bonds.
So, a high return on equity company, having a lot of leverage on the balance sheet, is a risk not worth taking.
I don't like such a company.
I want companies where the return on equity is high, and there is no leverage on the balance sheet.
2) High cash
Sometimes, you will find companies like Colgate, Castrol, Nestle, VST Industries, etc....
They have a lot of cash on their balance sheet.
They have little or no debt.
They have high return on equity.
But, if you observe the trend of the return on equity, over a period of 10 years, you will find that, the return on equity is falling.
Why does this happen?
This happens because, as cash keeps piling up, even if they give dividends, there is still a lot of money left on the balance sheet of the company.
That cash pile keeps increasing the equity of the company.
The denominator goes up.
Hence the RoE goes down.
Does it mean, it’s a bad company?
The names that I took just now, these are good companies.
Some of these are great companies.
Don't get fooled by the decreasing trend of return on equity.
3) Lower retained earnings
Some companies have such great earning power, that they don't need to retain any earnings.
Look at the balance sheet of Colgate.
They have given away, around 97% of what they have earned over the past 10 years, as dividends.
That's 97% of free cash flow.
Since there are no retained earnings, the equity remains small, and the profit keeps growing.
That magnifies the RoE.
In some cases, the return on equity remains more than 100%.
That's a fantastic business.
You have to look at RoE in multiple different ways.
It's not a static ratio.
You have to look at it over a period of time.
You have to compare it with other companies in the same sector.
That will give you a better idea of which company is the best in the sector.
4) Book value
When I say book value, I am talking about equity + retained earnings.
Sometimes, the assets are not shown on the balance sheet at their fair value.
Let's say a company had bought some land, maybe five decades ago.
That land is not shown at its current value on the balance sheet.
The increased value of the land does not get reflected in the balance sheet.
This artificially shows the equity as a small value.
Similarly, the intangibles. Some companies have great brand equity.
The brand has got a lot of value.
That brand value does not show up on the balance sheet.
So, the equity that we see in the denominator of the return on equity is understated.
Actually, the equity is much larger than what we see on the balance sheet.
So, if the equity is understated, that means the return on equity will be overstated, right?
Be careful while you study the RoE.
Pick your companies wisely.
Rohit Musale, CFA
5 January 2023