Table of Contents
- Understanding Return on Equity (ROE)/Return on Net Worth (RONW)
- Evaluating the Significance of ROE for Stock Market Investors
- Addendum: DuPont’s Analysis of ROE
- Readers’ Queries and Our Response
Many investors consider Return on Equity (ROE) a key metric to assess a stock’s attractiveness. However, we believe that ROE is not a reliable indicator of investment potential. Investors should not be swayed by high ROE figures often highlighted by company managements. Instead, they should evaluate a stock using a broader set of financial parameters. Before diving into why we don’t rely on Return on Equity, let’s first understand what ROE represents.
Understanding Return on Equity (ROE)
Return on Equity, also known as Return on Net Worth (RONW), is a profitability measure that indicates how efficiently a company generates profits from shareholders’ equity. It is calculated using the formula: ROE=Net Profit After Tax (PAT)Shareholder’s EquityROE = \frac{\text{Net Profit After Tax (PAT)}}{\text{Shareholder’s Equity}}ROE=Shareholder’s EquityNet Profit After Tax (PAT)
- Net Profit After Tax (PAT): This is the company’s bottom-line profit after all expenses, interest, provisions, and taxes. It represents the amount available for shareholders, either as dividends or retained earnings for future growth.
- Shareholder’s Equity (Equity): This includes the capital invested by shareholders and retained earnings accumulated over time.
Example Calculation
Consider two companies with the same equity base of INR 100 crore:
- Company A earns INR 10 crore in profits, resulting in an ROE of 10% (10/100).
- Company B earns INR 20 crore in profits, giving it an ROE of 20% (20/100).
At first glance, a higher ROE makes Company B seem like the better investment. However, this simplistic approach can be misleading.
Is ROE Meaningful for Stock Market Investors?
ROE can be useful for shareholders in unlisted private companies, where original investors acquire shares at Book Value Per Share (BVPS). In such cases, ROE accurately represents the company’s return on their invested capital.
However, in the stock market, investors rarely buy shares at BVPS. The price they pay is influenced by various factors, such as:
- Industry growth prospects
- Competitive advantage (MOAT)
- Market sentiment and demand
This price premium or discount relative to BVPS renders ROE ineffective for evaluating stock investments.
Example: How Market Pricing Distorts ROE
Let’s compare two companies:
- Company A: ROE = 10% (EPS = INR 1, BVPS = INR 10)
- Company B: ROE = 20% (EPS = INR 2, BVPS = INR 10)
Case 1: Buying a High ROE Company at a Premium
If strong demand drives Company B’s stock price up to INR 20 (double its Book Value Per Share (BVPS)), an investor purchasing at this price would experience: Effective Profitability=EPSAcquisition Cost=220=10%\text{Effective Profitability} = \frac{\text{EPS}}{\text{Acquisition Cost}} = \frac{2}{20} = 10\%Effective Profitability=Acquisition CostEPS=202=10%
Thus, despite Company B’s high ROE of 20%, the investor’s actual return is only 10% due to the premium valuation.
Case 2: Buying a Low ROE Company at a Discount
If weak market sentiment causes Company A’s stock price to drop to INR 5 (half its BVPS), an investor buying at this price would experience: Effective Profitability=EPSAcquisition Cost=15=20%\text{Effective Profitability} = \frac{\text{EPS}}{\text{Acquisition Cost}} = \frac{1}{5} = 20\%Effective Profitability=Acquisition CostEPS=51=20%
Despite Company A’s lower ROE of 10%, the investor’s actual return is 20%, making it a more attractive investment.
The Flawed Nature of ROE in Stock Investing
Since stock prices fluctuate constantly, each investor buys at a different price, leading to varying effective returns. ROE fails to account for market pricing dynamics, making it irrelevant for stock market investors.
Instead, investors should focus on:
- Buying wonderful companies at fair prices
- Avoiding overpaying for high-ROE stocks
- Seeking undervalued stocks with high Earnings Yield (EY)
The Right Way to Measure Investment Profitability
To make ROE useful, we should modify its formula to reflect the investor’s actual acquisition cost instead of BVPS: Effective Profitability Ratio=EPSCMP or Acquisition Cost\text{Effective Profitability Ratio} = \frac{\text{EPS}}{\text{CMP or Acquisition Cost}}Effective Profitability Ratio=CMP or Acquisition CostEPS
This Effective Profitability Ratio is commonly known as Earnings Yield (EY): EY=EPSCurrent Market Price (CMP)\text{EY} = \frac{\text{EPS}}{\text{Current Market Price (CMP)}}EY=Current Market Price (CMP)EPS
EY is more meaningful than ROE because it considers the actual price paid for the investment, just as Yield is more relevant than Coupon Rate in bond investing.
Additional Reasons Why ROE Is Unreliable
Beyond pricing distortions, ROE has other flaws:
- Inflated by leverage: Companies can artificially boost ROE by increasing debt (Dupont Analysis).
- Misleading book value: BVPS may include intangible assets, unrealized gains, and obsolete inventory, distorting actual net worth.
Focus on Earnings Yield, Not ROE
Instead of chasing high-ROE stocks, investors should seek stocks with high Earnings Yield (EY) to maximize their profitability. Buying an undervalued stock at a discount ensures higher long-term returns than paying a premium for a high-ROE stock.
As Warren Buffett wisely said:
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
By shifting focus from ROE to EY, investors can make smarter, value-driven decisions that enhance long-term wealth creation.
Addendum: DuPont’s Analysis of ROE
This addendum critiques Return on Equity (ROE) as a standalone metric and highlights the Dupont Analysis as a tool for breaking down ROE into its fundamental components:
ROE=(PAT/Sales)×(Sales/Assets)×(Assets/Equity)
ROE = (PAT/Sales) \times (Sales/Assets) \times (Assets/Equity)
ROE=(PAT/Sales)×(Sales/Assets)×(Assets/Equity)
Key Takeaways from the Analysis:
1. ROE Can Be Manipulated by Leverage
- The Assets/Equity component in Dupont Analysis reflects financial leverage.
- A company can boost its ROE by taking on more debt (increasing assets while keeping equity constant).
- This artificially inflates ROE, making the company look more profitable without improving actual business performance.
2. ROE Is an Outcome, Not a Cause
- Investors often assume higher ROE = better business, but the article argues that strong fundamentals (sales growth, profit margins, capital efficiency) lead to high ROE, not the other way around.
- Comparing ROE alone across peers ignores underlying business drivers.
3. The Right Way to Compare Companies
Instead of relying on ROE, the author suggests comparing companies based on:
- Sales Growth → Measures demand and competitive position.
- Profit Margins → Reflects pricing power and efficiency.
- Leverage Levels → Determines financial risk and sustainability.
Final Verdict
The author’s stance is clear: ROE is a misleading packaged metric. Instead of treating ROE as a deciding factor, investors should analyze its components individually to get a clearer picture of a company’s true financial health.
This aligns with Buffett-style investing, which emphasizes business fundamentals over financial engineering.
FAQs on ROE and Its Practical Use in Investing
1. How important is ROE in stock selection?
ROE is often considered an important metric for stock selection, but it should not be used in isolation. Instead, investors should analyze individual business parameters such as sales growth, profit margins, and leverage levels.
2. Can ROE be manipulated?
Yes, ROE can be influenced by financial leverage (Assets/Equity). A company can artificially boost its ROE by taking on more debt, which does not necessarily reflect strong business performance. This is why it’s essential to break down ROE using Dupont Analysis.
3. How does ROE impact long-term investment returns?
If a company retains all its earnings and maintains a high ROE, its intrinsic value should grow significantly over time. However, the initial purchase price matters. Even a high-ROE company can be a poor investment if bought at an excessive valuation.
4. What is the relationship between ROE and Price-to-Book (P/B) ratio?
ROE and P/B ratio are interlinked valuation parameters. A company with a higher ROE might deserve a premium valuation, but there is a limit to how much premium is justified. Investors must assess whether a high P/B multiple still offers a good risk-reward balance.
5. Is ROE a business performance metric or a valuation tool?
ROE primarily measures business efficiency, not stock market returns. It reflects how well a company generates profit from its equity base. However, investors should combine it with valuation metrics to determine whether a stock is attractively priced.
6. Why would management manipulate ROE?
Management may have various incentives to boost ROE artificially. For example, increasing leverage can enhance ROE, making financial performance look stronger. Additionally, high ROE can keep Employee Stock Option Plans (ESOPs) “in the money”, benefiting executives.
7. What does Warren Buffett say about ROE and valuation?
Buffett emphasizes that a great business can still be a bad investment if bought at too high a price. He warns against overpaying for high-ROE stocks, as excessive valuations can lead to poor returns over the long run.
