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| Roe, roe, roe your boat...Return on equity | The Intelligent Investor, 9/1/2001
Article from The Intelligent Investor Newsletter
Last issue we looked at return on
assets (ROA). This time it’s the
turn of its cousin, return on equity
(ROE). These two ratios are both linked
and vitally important tools. Even
Warren Buffett says so, frequently
stressing the importance of this figure.
His acquisition criteria are available
at www.berkshirehathaway.com
but the material is good enough to
reproduce some of it in the sidebar.
While ROA shows you what a
company’s assets produce, it doesn’t
reveal the actual return on shareholders’
capital. Why not?
Shareholders are the ultimate owners
of a company’s assets but they don’t
finance all of them. Lenders and
creditors also provide capital.
Items such as supplies bought on
credit (say 90 days), tax, or wages
earned but not yet paid, are known as
‘spontaneous finance’.
Interest free
This is effectively interest-free capital
which shareholders don’t provide, just
like the interest-free period on your
credit card. The ROA figure is
calculated before interest and tax, two
costs that must be paid before
shareholders receive anything at all.
So how do you calculate ROE? Easy.
It’s simply the net profit after tax
(NPAT), which you’ll find in the profit
and loss statement, divided by
shareholders’ equity, located in the
balance sheet.
A high ROA (say over 12%)
generally translates into a high ROE but
the reverse certainly is not always the
case. Here’s why.
If a company can earn more on
capital than it pays in interest, it can
leverage its return to shareholders
through borrowing. This is the same
concept as gearing into property or
using a margin loan. A company with an
ordinary ROA will often borrow to
increase its ROE.
There’s nothing wrong with this if
it’s done prudently. If not, it can place
the company in a dangerous financial
position.
Adelaide-based retailer Harris
Scarfe demonstrates how high gearing
can bring a company unstuck. The company’s assets were
producing an average, if unspectacular,
return with an ROA of 8.14% -
excluding dodgy profit ‘adjustments’ - in
the year to 31 July 2000. Through high
gearing (net debt-to-equity of 73%),
Harris Scarfe was able to lift its ROE to
an apparently respectable 12.81%.
It was this gearing that eventually led
to the company’s collapse. As Buffett
often points out, ‘to finish first, you
must first finish’. In attempting to
leverage returns to shareholders,
management overextended the business
and sent Harris Scarfe into receivership.
Average ROE
So, what’s an average ROE? We’d put it
at around 10-12%, although most
companies that have outperformed over
long periods have a higher ROE than
that. Harvey Norman for example, has
an ROE of around 20%, as does
Leighton. Westfield Holdings has an
ROE over 20% while Flight Centre’s is
over 40%.
Of these companies, some use
significant amounts of debt (Westfield)
and others use very little (Flight
Centre).
Again, it’s important to look behind
the numbers and really understand the
type of company with which you’re
dealing.
Article from The Intelligent Investor Newsletter |
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