Understanding ROE (Part 2)

Today I will delve deeper into Return on Equity (ROE) at the risk of offending some readers with some higher-level math and accounting concepts.

As discussed in Part 1, ROE is a primary indicator of a company’s profitability and management efficiency by measuring dollars of profit generated per dollar of shareholders’ equity:

• High or rising ROE suggests management is efficiently using shareholder capital to generate earnings.
• Consistently high ROE (e.g. 15-20%+) often signifies a strong economic moat or superior business model.
• ROE may be used to determine a company’s sustainable growth rate by calculating the pace a company can grow internally generated profits.
• ROE allows investors to compare corporate performance within the same industry.

Beware of potentially “bad things” that can mislead by resulting in a high ROE. The third term of (1) in Part 1 has shareholders’ equity in the denominator. Since that equals assets minus liabilities, taking on excessive debt minimizes this term thereby boosting ROE. Share buybacks reduce shareholders’ equity resulting in higher ROE even when net income remains flat. Large asset write-downs also reduce shareholders’ equity potentially inflating future ROE. Years of negative earnings can deplete shareholders’ equity thereby resulting in artificially high ROE noticed when profitability is finally realized.

Follow these tips to use ROE effectively. First, compare a stock against industry average because ROE can vary dramatically (e.g. tech companies often have higher ROE than asset-heavy utilities). Second, ensure ROE is sustainable by looking at a 5-10-year average and trend [stable or increasing is good] rather than single quarter. Third, DuPont Analysis [(1) in Part 1] is good to see what is driving the return. Finally, cross-referencing with return on invested capital (ROIC) can help understand if high ROE represents operational strength or just cheap debt.

ROIC = NOPAT / Invested Capital

In the numerator, NOPAT is Net Operating Profit After Tax and represents profit a company would have without debt or excess cash. NOPAT = EBIT * (1 – tax rate) where EBIT [may be substituted by operating income] is earnings before interest and taxes. NOPAT strips out the effects of leverage or different financing structures.

In the denominator, Invested Capital may be calculated two ways. The financing approach sums up the sources of capital: Total Equity + Total Debt – Cash & Equivalents, which simplifies to Total Equity + Net Debt. Alternatively, the operating approach focuses on assets used in operations: Total Assets – NIBCL. Non-Interest Bearing Current Liabilities (NIBCL) usually includes accounts payable and accrued expenses.

By ignoring how the business is funded, ROIC enables comparison of business quality—the ability to generate high returns on capital over a long period protected by a competitive advantage not easily disrupted by rivals—even if one is debt-free and the other is highly leveraged.

Bonus math for today: compare ROIC to Weighted Average Cost of Capital (WACC) for a true sense of value creation. If ROIC is 12% and WACC is 5%, then the company is creating 7% of value for every dollar it touches.

In reality, doing this comparison is not so simple. I would really make enemies today if I presented the WACC equation with its six different inputs. Many of these inputs are subjective and it’s not uncommon to have analyst disagreement up to 1.5%. While that may not impact the just-mentioned “true sense of value” so much, it’s also used as the discount rate in discounted cash flow models where a 1% WACC difference can change a stock’s intrinsic [or “fair”] value by 10-20%.

Please take a breather! If not for you, then take it for me.