The perils of return on equity

Investors using simple return on equity measures to value Forge Group have just lost their shirt. Nathan Bell explains a better way to use this much-vaunted ratio.

Investors have just lost a bundle on engineering company Forge Group as it skirts with bankruptcy due to massive losses suffered on two major projects. This is typical of the contract engineering and mining services industries, as I learned the hard way nearly 20 years ago after making one of my first ever investments in contracting company Eltin Limited, which was eventually acquired by Leighton.

Search the internet and you'll find plenty of 'analysis' cheering on Forge's management, the company's conservative balance sheet and its high return on equity. Many seemed to think the company could continue to reinvest at extremely high rates of return forever.

As I explained in Avoiding mining services (for now), reducing your analysis to a mathematical equation based on high returns on equity without an accurate understanding of the sustainability of the company's profits is extremely risky. This is particularly the case for highly cyclical businesses that must compete for new contracts year after year, as Forge has just demonstrated.

Key Points

  • ROE can flatter a business in the short term
  • Analyse business factors to assess sustainability
  • It also matters how much can be reinvested at attractive rates

There is no substitute for understanding what makes a business tick, but the return on equity can help you decide between different stocks after you've done your research.

Reinvestment is a privilege

Let's start by comparing two companies in the same industry, A and B. Company A has a return on equity (ROE) of 18% and pays out 75% of its profits as dividends. Company B has a return on of equity of 15% and pays out 70% of its profits. Which stock would you prefer to invest in?

Assuming that the two companies' return on equity figures are equally sustainable, that their businesses are of equal risk and that you got the same starting dividend yield, you could pick either.

When you buy into a stock sporting a premium ROE, you're buying the privilege of reinvesting your earnings at a high rate of return – but that privilege extends not only to the actual level of the ROE, but also to the amount of money you can reinvest at that rate.

So although Company A offers the higher ROE, Company B is still attractive as it is able to reinvest more of its earnings at these rates. In this example, these two factors offset each other and, using the formula [Growth = (1 – Dividend Payout Ratio) x Return on Equity], both companies will increase their profits and dividends at the same rate – as you can see in Chart 1. Note that we've had to start the lines for A and B at slightly different points so they don't sit right on top of each other, but the gap between them remains the same, at least in percentage terms.

New opportunities

Let's say Company B managed to find a bunch of new opportunities requiring large investments and only paid out 55% of its earnings as dividends. Under this scenario, Company B would be the superior investment even though it would take 13 years for dividends to pass where they'd have been under the first scenario (see Chart 2).

This has important implications for investors weighing up faster growth tomorrow or higher income today. But since it's usually mature companies that pay high dividends, it's highly unlikely they'd find such opportunities without taking very large risks, which would most likely produce poor returns and a lower return on equity. This is why we generally prefer mature companies to pay out higher dividends rather than make risky acquisitions.

In the original scenario we assumed the same starting dividend yield for each stock, but this would in fact result in a higher price-earnings ratio (PER) for Company A, which is paying out more of its earnings. In fact, using the Gordon Growth Dividend Model (the Forager Funds blog post mentioned below covers the gory maths) and assuming you want a 10% annual return, you'd be prepared to pay a historic PER of 14.3 for Company A and 13.3 for Company B.

While both companies are expected to grow at the same rate, you can afford to pay a little bit more for Company A relative to its earnings, because more of those earnings show up in your bank account every six months. But moving on to scenario 2, you'd pay a much higher PER for Company B – 18.1 in fact – to account for its higher growth rate (we're assuming of course that this higher growth can be maintained).

Grounded in reality

As you might have suspected, this hypothetical case is grounded in reality. Based on recent ratios (or as near as makes little difference) Company A is Commonwealth Bank and Company B is ANZ. So what conclusions can we make?

First, for ANZ to be a better investment than Commonwealth Bank, you either need to pay a lower PER, or the company's return on equity needs to get closer to Commonwealth's, or it needs to find more opportunities to reinvest its earnings. And it is perhaps an acceptance of its relatively low ROE and the hope of finding further opportunities that is driving a much risker strategy. This risk isn't captured by mathematical valuation tools, which is one reason why they so often steer unwary investors into trouble.

Second, you cannot boil down an investment into such a simple, mathematical framework without a thorough understanding of the businesses to work out what a sustainable return on equity figure might be. The more complex and less predictable a business is, the less confidence you should have in your estimates of return on equity.

This is the lesson from Forge Group, as we explained last week in Forge and the fine art of stockpicking. It's much harder to lose your money using similar shortcuts to value Woolworths, for example, which is a far more reliable business.

Third, all things being equal, companies with the ability to invest at high rates of return are likely to prove the best investments – but this applies not only to the high rate of return, but also the availability of investment opportunities. The more a company invests the faster it should grow, but trees don't grow to the sky; every company matures eventually, and all markets and products have limits to their growth. Success also invites new competitors.

Lastly, as Benjamin Graham said, 'price is what you pay, value is what you get'. Even though a company may produce a low return on equity, it may be mispriced and offer far higher returns as its share price returns to fair value. On the flipside, buying high-quality businesses sporting high returns on equity isn't sufficient to save you from losses. The difference between a great company and a great investment is the price you pay.

Note: For another example, in Why NewsCorp needs to grow and Telstra doesn't Steve Johnson explains why a company like NewsCorp that retains all its earnings needs to grow its profits by 10% each year to offer the same return as Telstra, assuming it pays out virtually all its profits for a sustainable 10% grossed up yield (taxes aside). This is one reason why investing in growth stocks can be risky. Once the high growth phase is exhausted return on equity can shrink quickly, along with the share price.

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