- Investment strategies
- Why invest in the stock market?
- Buy and hold or technical analysis? Why you need an investment plan
- Value investing and short selling in volatile markets
- Using technical analysis to support value investing
- Investing in the unexpected
- Franking credits, explained
- What is dividend stripping and is it a sensible strategy?
- Investing in quality IPOs
- How to invest in stocks that benefit from a moving Australian dollar
- Reasons to avoid bonds when interest rates are low
- How value investors use Skaffold
- Quality, growth and value = a winning strategy
- Know your investor type and boost your performance
- Technical + fundamental analysis = better buy and sell decisions
- Fundamental investing
- Value investing and the price earnings ratio
- Intrinsic valuation models and methodology
- Value investments or value traps?
- How to find value stocks in a bull market
- Find value investments in expanding markets
- Why capital raisings struggle to add investment value
- How to value an insurance company
- Top stocks
- 5 qualities of top stocks
- How to find stocks with a competitive advantage
- Why return on equity is the best measure of business performance
- Using cash flow to find value investments
- Finding high quality dividend stocks
- Debt is not always a dirty word
- Why Skaffold share investment software makes sense
- Using economic factors to uncover the best investment options
- How do experts find top stocks to invest in?
- Investing in global stocks
- How to invest in international shares on global stock markets
- Benefits of investing in international shares
Why return on equity is the best measure of business performance
ROE determines the level of profitability a company earns on the equity capital it has raised and retained.
While no one tool for successful investing should ever be used in isolation, return on equity (ROE) is regarded by Skaffold as the single best indicator of business performance, so long as debt levels are rational. As a key measure of how well a company is managing its equity, return on equity – net profit divided by (shareholder) equity – determines the level of profitability a company earns on the equity capital it has raised and retained.
Return on equity and business performance
A simpler way to look at profitability is to identify whether every $1 used in financial growth is able to convert into $1 of market value, or not. An important overlay that Skaffold uses to best reflect ROE in the right context is a review of each company’s balance sheet gearing and how much debt was needed to deliver those earnings. It’s known as the Capital History Evaluate screen, and has a patent pending because of its unique interpretation of a company’s history of equity, debt and business performance. Skaffold’s Capital History Evaluate screen for every ASX-listed company (and another 2,000 global stocks) will help to expose any distortion in reported earnings.
Take a look at Fortescue Metals Group (FMG). In 2012 FMG generated a return on its equity in excess of 50 per cent. This impressive performance however was achieved with the assistance of debt (red column) amounting to more than $8 billion, or more than one and a half times the equity (grey column) in the business. In 2012 Skaffold calculated FMG ended its financial year with a net debt-equity ratio of 164 per cent. Skaffold prefers companies whose balance sheet is geared at a net debt/equity ratio of less than 40 per cent.
Skaffold’s Capital History Evaluate screen presents FMG’s history of equity, debt and return on equity
Debt levels will reveal a lot about the company’s ability to reinvest at the same ROE in the future. As a stock picker, it’s important for you to understand how sustainable that profitability is. Let us explain further using the following example.
Your business started the financial year with $100,000 in the bank, and ended it with $200,000. At face value you made a $100,000 profit. But during the year you borrowed $200,000 – bringing your bank balance back to zero – and raised an additional $150,000 in equity, leaving you with a cash loss of $150,000. Adding to the false impression of your business improvement and a further distortion to the ROE, you also borrowed to pay a dividend of $200,000.
Business performance and debt servicing
As a value investor, you should be looking for stocks that can deliver a return on equity above Skaffold’s recommended 15 per cent. Identifying businesses capable of delivering a significantly greater ROE will build in a recommended margin of safety. How much of a safety margin is desirable will depend somewhat on the state of a company’s balance sheet.
Admittedly, the better the underlying cash flow, the greater a company’s capacity for balance sheet gearing. US-listed International Business Machines (IBM) is a great example.
While IBM’s balance sheet is geared at more than 115 per cent, the company has consistently produced enough cash to more than cover its debt obligations. Since 2003 Cash Flow Generated from Operations has exceeded Reported Net Profit After Taxes – a rare achievement indeed.
But assuming debt levels are modest – typically with net-debt to equity under 30 per cent – companies with higher ROE should have higher levels of profitability.
Australian companies’ profitability
Interestingly, the return on equity of the great bulk of ASX-listed businesses (Skaffold estimates around 60 per cent) is insufficient for them to be regarded as profitable. Size is no determinant of profitability, with many large-caps ($2 billion-plus market cap), such as Alumina (AWC) and Whitehaven Coal (WHC), included amongst those with negative profitability. So assuming ROE is used as an important filter, the stocks left in your universe have already been culled to around 30 per cent of the entire Australian Stock Exchange.
If a company isn’t profitable, or forecast to be profitable, an intrinsic value cannot be estimated by Skaffold, so a Safety Margin cannot be calculated. Based on Skaffold’s automated ranking of profitable ASX-listed stocks, just under 20 per cent offer a positive safety margin. Companies in the mining and healthcare sectors are the worst offenders where those deemed unprofitable exceed 80 per cent.
So in a market where value-for-money is perennially hard to find, ROE serves as a useful insight into profitability, but only if it’s used in the right context. While it won’t of itself indicate what a Skaffold Score should be, or whether shares are valued higher than the worth of a business, ROE will help cull the colossus of stocks that should not be on your radar due to insufficient profitability.
Remember, the value-for-money proposition is constantly changing along with share price movement. That’s why it’s important to regularly review the cash position of your companies. If they’ve spent more than they’ve earned, and raised capital and taken on debt, then there could be a time bomb ticking in your portfolio.