4 Reasons ROE Is Not A Useful Metric For Investors

4 Reasons ROE Is Not A Useful Metric For Investors…more attention to return on invested capital (ROIC)

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Recently, we ran through the various flaws in the price to earnings ratio and explained why investors need to be paying more attention to return on invested capital (ROIC). This week, we’re tackling another of the market’s favorite metrics, return on equity (ROE).

Return on equity has a very simple formula:

It’s tempting to think of ROE as just an easier-to-calculate version of ROIC. All you need to do is just find the Net Income line on the Income Statement and divide it by the Shareholder’s Equity line on the Balance Sheet. Unfortunately for investors, a metric that’s so easy to calculate is rarely going to be useful in terms of explaining valuation, as Figure 1 proves.

Figure 1: ROE Has Almost No Impact On Valuation

Sources: New Constructs, LLC and company filings.

Figure 1 shows the relationship (or lack thereof), between ROE and enterprise value/invested capital, which is a cleaner version of price to book. Less than 1% of the difference in valuation between S&P 500 companies can be explained through ROE. A similarly nonexistent relationship shows up when we plot ROE against the P/E ratio.

Figure 2: ROE Doesn’t Impact P/E Either

This evidence is clear. No meaningful relationship exists between ROE and P/E or enterprise value/invested capital[1]. It has an appealing simplicity, but ROE has several fatal flaws that keep it from being a useful metric.

Flaw #1: It’s Based On Accounting Earnings

I’m not going to belabor this point because it’s one we’ve made time and time again. Reported net income is not a useful metric for equity investors. GAAP rules were designed for debt investors, and GAAP net income has a number of issues that make it especially poor at measuring profitability.

  • It contains many accounting loopholes that can distort reported earnings.
  • There’s almost no enforcement in place to keep executives from manipulating earnings.
  • Changing accounting rules and differing interpretations mean net income is not necessarily comparable over time or between different companies.
  • Financing costs such as interest can impact reported earnings, obscuring the actual operating performance.

ROIC fixes these issues by using net operating profit after tax (NOPAT) as the numerator. Unlike GAAP net income, NOPAT excludes financing costs, uses consistent rules across all companies and timeframes, and adjusts out the impact of unusual items and changing management assumptions.

Flaw #2: It Ignores Off-Balance Sheet Items

Companies have all sorts of tools they can use in order to hide assets off the balance sheet. One of those tricks, using operating leases as off-balance sheet debt, is going to get taken away in 2018. Still, there are other hidden off-balance sheet items, such as reservesdeferred compensation, andasset write-downs.

These all represent committed uses of capital for which the company is not being held accountable. This is an area where we really see how accounting rules are geared towards the needs of debt investors rather than equity investors. Writing-down assets helps debt investors by giving a clearer picture of the liquidation value of a company, but it hurts equity investors by obscuring the true amount of capital invested in the business.

We use invested capital for the denominator in our ROIC calculation because it factors in these hidden items so that the company is being held accountable for all of its uses of capital.

Flaw #3: ROE Can Be Influenced Through Leverage

A true measure of profitability should be focused on the operating side of the equation, without allowing financing decisions to have a big impact. By only using shareholder’s equity as the denominator, ROE becomes extremely susceptible to financing decisions, as a company can significantly boost ROE by taking on more leverage and increasing its risk.

The opposite also holds true. A company holding a great deal of excess cash will be penalized with a lower ROE, even though it may be making the responsible decision to hold that cash until a more opportune time arises to invest it at a higher return or to return that cash to shareholders more efficiently.

As an example, let’s look at Nordstrom (JWN) and Apple (AAPL). According to ROE, Nordstrom is the more profitable company, with an ROE of 47.9% compared to Apple’s 44.7%. This misleading comparison stems from the fact that Nordstrom’s total debt is equal to 41% of its market cap, whereas Apple has over $130 billion in net cash (20% of market cap).

When we remove the impact of leverage and just look at the operating profitability of these two companies, we can see that Apple has an ROIC that is more than 10 times higher than Nordstrom.

Flaw #4: Executives Have An Interest In Manipulating ROE

ROE is another one of the “advanced” or “non-GAAP” metrics that companies often use to set performance targets that executives need to hit to earn their annual and long-term bonuses. Consequently, executives will be more likely to manipulate accounting earnings, structure transactions to keep them off the balance sheet, and take on more leverage in order to boost ROE.

Because ROE is so easy to manipulate, and because executives potentially have such a strong interest in artificially boosting it, investors can’t know whether that ROE number is reliable or just a result of financial wizardry. One company might have a significantly higher ROE than a competitor simply because it’s more aggressive exploiting accounting loopholes rather than being superior in terms of profitability.

The ease with which ROE can be manipulated, as well as its various structural flaws, explain why it has almost no value in terms of explaining differences in valuation. As we see so often in the market, simplicity is not always a virtue. ROIC might not be as simple to calculate, but it’s a much better indicator of profitability and valuation.

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.

[1] We explore the often misunderstood relationship between ROE and price-to-book in this report.



FTSE 100, UK economy, a new way for indexation

Why we should ditch the FTSE 100

Britain’s benchmark index tells us little about the state of the UK economy

For a new year’s resolution, the media, the markets and the stock exchange should ditch the FTSE and find another index instead.

Yes, and here with Maltaway we have the solution with a SMART Fundamentals driven financial product

The economy grew at one of the fastest rates in the developed world. Employment hit record levels. Inflation dropped to 50-year lows. And a pro-business centre-right government was elected with a clear majority for the first time in over two decades.

After so much went right for the UK economy this year, anyone checking their year-end portfolio might expect the FTSE to be comfortably ahead for the last twelve months.

But hold on. With just a few trading days left, the FTSE is likely to end slightly down for the year. Despite a steady recovery in the economy, that will make it three years in a row that the benchmark British index has been essentially flat.

“The FTSE itself only dates back to 1984. We would hardly be losing a long tradition by replacing it”

To some degree that might be telling us that the economy is not quite as strong as it might look on the surface. But, more significantly, it is telling us that the FTSE has become completely unfit for purpose. It no longer reflects what is happening in the British economy.

After all, France’s CAC-40 is comfortably ahead for the year. So is Germany’s DAX, even though neither economy has done as well. As 2016 opens, it is time we retired the index – and came up with something that worked better.

It is hard to argue that the British economy hasn’t had a decent year. You can always pick holes in the performance of any mature nation, and ours is no different.

The yawning trade deficit is worrying, and productivity is stagnant. Even so, the overall performance is very strong. Growth is expected to come in at 2.3pc for the year, after an expansion of 0.5pc in the third quarter. The employment rate has surged to 73.9pc, the highest figure since records began in 1971. Wages are starting to grow again. Price rises are so subdued that the Bank of England is more worried about how to get inflation up rather than down.

You might imagine that would translate into stronger equity markets. After all, if companies can’t make money in that environment, when can they? The trouble is, it hasn’t happened. The FTSE-100 index opened the year at 6,366. It is closing it at around 6,100. Basically it hasn’t moved. That is hardly the first time that has happened.

Re-wind to 2014, and the UK also had a fairly decent year, with the economy recovering. The FTSE, meanwhile, drifted from 6,700 to 6,300. How about 2013? It was slightly better, with the index nothing up gains of close on 10pc, nearly all of which it has since given up. But if you take the last three years as a whole, the index is has been as flat as a pancake.

That is telling us something significant – that the FTSE is not in the least representative of the British economy.

Where has the growth come from in the last three years? It has come from the start-up boom, with more than half a million new businesses being created every year. It has come from a rapidly developing technology sector, and booming professional services, such as consultancy, engineering design and law. And it has come from the rapid growth of self-employment, especially at the top end of the labour market. None of that, however, is reflected in the FTSE.

“Growth is coming from small and medium-sized companies”

Instead, the index is dominated by the sectors you least want to be in right now. The oil and commodity giants such as BP, Rio Tinto and Glencore make up a huge chunk of the index. But the collapse in oil and other raw material prices means those companies have all performed horribly. The banks which make up another big chunk of the index are under pressure from zero interest rates, and assailed by new web-based competitors. High Street retailing is in deep structural decline. True, there are regular re-shuffles. But the new companies are only rarely much better – of the latest additions only the financial technology company WorldPay is at all exciting.

If you look away from the FTSE, you will find that smaller companies are doing much better, and their indexes reflect that.

Take the FTSE-250. It has had another good year in 2015, rising from 16,000 in January to slightly over 17,000 now. If you measure it over the last three years, the performance is even better. It was at 12,600 at the start of 2013, so it has risen by more than 30pc since then. Or take the AIM 100 index, which measures the performance of best small companies that are not yet on the main market. It has risen from slightly over 3,000 at the start of the year, to 3,400 now, a gain of more than 10pc this year. Both are far more representative of how the British economy is doing. Why? Because the growth is coming from small and medium-sized companies.

Other countries don’t have this problem. The Dow is fairly representative of the American economy, and will be even more so if, as many expect, Amazon and Alphabet – as Google now calls itself – are added to the index. The German DAX, with companies such as BMW, Siemens and ThysenKrupp is a pretty good reflection of that country’s mighty manufacturers and exporters. Likewise, France’s CAC-40 reflects an aging but still strong base of luxury good manufacturers and engineering companies. Take a look at any of them, and you get a pretty good idea of how the economy is doing.

That is not true of the FTSE . That matters. The performance of the main index dominates the news. It is what you hear quoted on the TV or radio every day. It is the benchmark for investment, and the standard against which portfolios are measured. The risk is that its dire performance creates a mis-leading impression, deters global investors from the UK, and puts people off saving and investing.

It doesn’t have to be like that. It would be perfectly possible to create a new index that reflected the broad make-up of the British economy, with an emphasis on smaller companies, technology, media, and services, which are our real strengths.

After all, the FTSE itself only dates back to 1984. We would hardly be losing a long tradition by replacing it.

For a new year’s resolution, the media, the markets and the stock exchange should ditch the FTSE and find another index instead.