“Investment is most intelligent when it’s most businesslike”- Benjamin Graham.

Both Benjamin Graham and Warren Buffet have emphasised on the need for the investor to only invest in companies whose business they duly understand.

But how do we do that?

The answer lies in an obsession with numbers. Plain odd numbers that mean something to a blank eye.

Just like the Greeks had an obsession with Golden Ratio, investors are the same with Financial ratios. Ratios are shortcuts and who doesn’t like them? Especially when “more time means more money”, seems real.

One such important ratio that makes the kitty of the most important financial ratios to consider for an Investor is the “Return on Equity (ROE)” Ratio.

And both these gentlemen mentioned above love this ratio. They do warn you on single-factor investing and urge you to consider other key factors but that’s in line with every valuation metric that comes with a “yes, but…”. 

But why do they love it?

Because it’s businesslike. It showcases the business owner’s ability to employ equity into money-making ventures. It measures profitability. It gives a raw sense of what the company is doing with its equity and how efficient it is in engineering its cash to generate more cash. More earnings mean higher valuations and higher valuation would mean capital appreciation for stakeholders. It’s simple math.

But, as all math do,

It starts with a simple formula.

Return on Equity (ROE) = Net Income/Shareholder’s equity.

Toggle to the company’s P&L statement and pick up the bottom-line item, ‘Net Income’ and divide it by the total shareholder’s equity present on the balance sheet and that’s how easily you can calculate the ROE of your desired company. The rule of thumb is, the higher the ROE, the more the company is efficient in its operations.

Too excited to already switch tabs? Wait!

This is where the trouble begins. 

The simplicity by which ROE can be calculated should already make you apprehensive about its god-like relevance. Good things don’t come easy, right? Well, let’s dig deeper.

Let’s multiply and divide the above equation, once by the ‘Total Sales’ and again by ‘Total Assets’.

ROE= (Net Income/Total Sales) * (Total Sales/Total Assets) * (Total Assets/Shareholders Equity)

Total Sales cancel Total Sales and Total Assets cancel Total Assets but for now, let’s analyse each portion individually. Reframing the above equation, we have:

ROE= Net Profit Margin * Total Asset Turnover Ratio * Financial Leverage

What we have is something known as the DuPont Formula which breaks down ROE into 3 key drivers, all of which independently relate to the ROE and can help back-test the components of the formula.

The Net Profit Margin is indicative of how well the company is in managing and financing its operations per unit of sales. A higher Net Profit Margin would eventually mean more earnings for the company and higher ROE. Asset turnover ratio means how efficiently the company is using its assets to drive sales. A higher Total Asset Turnover Ratio would mean that the company is deploying its assets correctly to target higher sales per unit of the asset owned. Hence, a higher ROE. Lastly, Financial Leverage is the extent to which the company uses debt in relation to equity to finance its assets. In brief, higher leverage would mean greater financial risk but substituted by higher Return on Equity (ROE).

An ideal firm should have a high Net Profit Margin, high Asset Turnover Ratio but use less leverage to reach there.

It turns out, however, that a company cannot grow earnings faster than its current ROE without raising additional cash. Now raising cash comes at a cost and cuts through the firm’s profits. If the company decides to raise money by way of debt, the interest gets paid as an expense and if it decides to raise equity, Earnings-per-share (EPS) goes down, which in turn affects investor sentiment.

So, ROE is the limiter to a firm’s growth. It’s a gauge against the excessive heating up of the company. That is why ROE forms an integral part of the investor analysis but here comes the catch. When something holds such importance within stakeholders' minds and the management knows it, will not all companies tend to magnify ROE to seem better on the stock exchange? 

Yes, but soon you’ll know higher ROE numbers are no shortcut for diligence.

Manipulating the ROE numbers isn’t an ordeal. There are numerous ways by which this can be done and that make higher ROE’s a subject for debate. This is where the trouble gets bigger.

Share Buybacks:

Remember the ROE equation? A simple math student would tell how to increase its value. Either increase the Net Earnings (Numerator) or decrease Total Shareholders Equity (Denominator). An ideal and natural practice for companies would be to focus on increasing the numerator by increasing the Asset Turnover Ratio that drives sales with no additional asset cost or by increasing the Net profit Margin by efficiently managing operations. Both these practices done in tandem would result in a significantly higher ROE. But not all companies resort to this technique. Some adopt a latter technique and decrease shareholder’s equity by rolling out share buyback schemes. When they do say they use the retained earnings to buy stock and thus decrease the shareholder equity which in turn magnifies the firm’s ability to turn equity investments into profits (ROE).

High Leverage:

Another way to decrease shareholder equity is to tweak the company’s capital structure by playing around with the Debt/Equity ratio. Companies issue debt to raise capital and then use that to generate profits. Indeed, the finance cost will increase for a given capital requirement but that would only be a fraction of total debt and not enough to offset the decrease in shareholder’s equity. Higher Net Profits would boost ROE higher, but that has hidden risks related to insolvency and inability to survive during economic downturns. Because debt is an obligation to pay back with interest, it is neutral to the company’s bad run. Companies that issue large debt run the risks of overleveraging in the form of high-interest payments and greater chances of default. These companies may rely heavily on debt and hence have an Inflated and misleading ROE figure.

Off-balance sheet items and write-downs:

The concept of Off-balance sheet items has been in talks ever since Sir David Tweedie was the chairman of the IASB. He joked that he wanted to fly in an aircraft that actually existed on an airline’s balance sheet. That is to say that it’s not on operating lease or any such way that the companies adopt to evade showing huge assets in their balance sheets. By doing this, they forgo depreciation expense and incur impairment charges when they right down assets, which in turn decreases Shareholders' equity on the balance sheet. This keeps equity investors in an obscure environment by hiding the true amount of capital invested in the business. This is further treated maliciously by the management to offset natural ROE figures and make them appear more inflated and following a growth trend.

Another problem with the ROE calculations is the ‘E’ part in it. The “Net Earnings” line item is such an entry that can easily be tricked and especially when the management bonus is linked to hitting ROE targets, they can have a strong interest in artificially boosting it. Further, it does not take into account risks associated with income generation and is subject to a wide variety of accounting conventions.

Conclusion:

Since the number is so susceptible to management intervention and unchallenging to intrude and alter, higher ROE can be misleading. If not anything this is what companies did in the wake of the 2008 Financial Crisis and during the ongoing Covid-19 Pandemic. Since the market was undervalued on both occasions, companies came in with various offers to interest investors and appear good on paper. This rigorous attempt was also done to avoid a dent in the ROE history of the company. An ROE that’s greater than the return available from a lower risk investment motivates the Investor to see interesting but false prospects building within the company.

While companies do all this to fuel their investor's confidence, misinformed investors are caught in a tyranny of financial malpractices, unwinding which is a luxury for a common Investor. Investors can’t know whether that ROE number is reliable or pumped to perfection. One company might have a significantly higher ROE than a competitor simply because it’s more aggressively exploiting uninformed investors rather than being superior in terms of profitability. ROE lacks the necessary meticulous conscientiousness to buttress intelligent investment decisions.

Though every single ratio has a caveat. ROE is the dumbest of all.

I’ll leave you with one thought, though.

If such a flawed financial metric catches the attention of mass-market participants, then there should be a profitable arbitrage strategy that exploits that anomaly?