How Return on Equity Is Deceiving You
Analysts love Return on Equity (ROE) when analyzing companies. They love it because it separates good companies from bad, at least that is the thought process behind this indicator. However, you will discover how Return on Equity is deceiving you when you read this article.
Suppose the ROE for one company is 22 and for another company is 8, is the first company a superior company? In the eyes of most financial analyst, the answer would be yes.
For the most part, this is true. To illustrate why this is, consider you open a business, say a lemonade stand. Let’s assume you put $100 into this business, and after your first month, your net profit is $25. This net profit is after every cost that is associated with selling the product and advertising, and so on. The $25 belongs to the business. If you do nothing else with the business at the end of the year, the equity in your business is now $125. That $25 is added to your equity (assuming you leave it with the business and don’t withdraw it).
What is the return on your equity? You had a return of $25 on that equity of $100. Therefore, the ROE for your business is 25%. If a competitor in another neighborhood only made $15 on his $100 equity investment, then his ROE is 15%. As you can see, your business is stronger than your competitor.
The concept of ROE is not much different for corporations. They have more complicated components that make up their income statement than you do for your lemonade stand. But, the calculation still takes the net income and divides it by the Shareholders Equity.
Assets Are the Cornerstone of Making Money in Business
The way business owners make money in business is they buy assets that have the potential to earn money. Those assets could be a printing machine for brochures. In the case of your lemonade stand, you bought a cart and all the supplies. These are all assets that were used to create the finished goods to sell to customers.
This concept is crucial to understand and a failure to do so is where the deception lies with Return on Equity.
How Assets Are Funded
Most business owners don’t start out with assets. Even if you have cash to give to the business, that bootstrap event had to occur before the business officially had the means to purchase assets that will start earning for the business.
In the case of your lemonade stand, you likely did not hit up a bank for funding. It wouldn’t be something a bank would take seriously. Most lemonade stands are cash-only businesses without any borrowing. You could technically borrow from family members to get your venture started. However, family members aren’t going to come after your assets if you don’t pay them back.
The point here is that the method you paid for your assets was through the equity you put into the business, i.e., the $100. That doesn’t represent any debt.
Bigger companies will often use a mix of debt and equity to pay for their assets. The right mix depends on the business, what they sell, and the industry they operate in.
You could argue that you paid cash for the assets of your lemonade stand business, and that is true. The cash belongs to the business and that cash is part of the equity. Think of a house that you purchase. When you put 20% down on a $100,000 mortgage, you have $20,000 in equity. You paid cash for that 20% down but it is now considered equity in your home. For a business, the concept is similar. You give the business $100 which means there is $100 equity in the business.
What if were able to borrow $900 for your lemonade stand and it was in the form of a bank loan? Perhaps you are thinking of cornering the market in your neighborhood and your banker is head-over-heals in love with your lemonade. You have $100 equity invested in this business and the bank owns $900, at least until you pay off the loan.
Let’s also suppose that in both scenarios (non-loan and loan) that your business doesn’t make it? What happens in both of these scenarios?
For the non-loan scenario, the biggest impact is that you are out $100. It stinks, but no one else is hurt by this event. You gave it the old college try but you simply couldn’t make it work.
Of course, you have every right to try to liquidate the assets of your lemonade stand. Maybe your competitor is looking to expand and will buy your cart and supplies for $40. This reduces your loss to only $60. No one would blame you for trying to get something for your efforts.
For the second scenario, where the banker loaned you $900, what happens in this scenario when your business fails? In this scenario, the banker owns $900 of your business. The banker has first access to the assets of your business. If you used that $900 to buy a car for your lemonade business, you would likely need to forfeit the car to the banker. Small businesses often have to put up collateral or personal guarantees for loans. If there is anything left of the business after the creditors liquidate, then the business owner has claim to any remaining assets.
Usually, there is nothing left as liquidations are pennies on the dollar. The banker won't get his full $900 back, and will try to liquidate as many assets as the business owns to come as close to possible to recouping the loss.
What About the Deception?
The deception comes from the creditors having first rights to the assets of a company if liquidation were to occur. Successful businesses can use the money lent by the creditors to purchase assets that will return value in excess of the loan. In other words, they'll be able to pay off the loan over time. This is debt that is serviceable.
Conversely, unserviceable debt won’t generate enough cash to pay back the loan. Companies will need to find other ways to raise the money to pay back the original loan. If they resort to more lending, this could get them in further trouble. An example of unserviceable debt would be paying bonuses to management. This won’t have a direct impact net income, at least not in the short term.
It’s not readily apparent how creditors affect the ROE for a company. The problem is that the formula for ROE commonly used is a factored version of a bigger equation.
Most analysts use the short-form of the equation, namely, the Net Income / Equity. On the surface, this doesn't seem to tell us much how leverage could cause a business to fail. The secret is hidden in the longer-form of the ROE calculation.
The true ROE has three components, the profitability ratio, the efficiency ratio, and the leverage ratio. This forms the basis of a concept called DuPont Analysis. It is sometimes called the DuPont Framework, too. An employee of the DuPont company derived this concept over 100 years ago, hence the name.
The full formula for ROE is as follows:
Profitability Ratio x Efficiency Ratio x Leverage Ratio
Profitability Ratio = Net Income / Sales
Efficiency Ratio = Sales / Assets
Leverage Ratio = Assets / Equity
You may recognize the Net Income / Sales as the profit margin, and that is exactly what it is. It helps us learn how strong the profit for the company is.
The efficiency ratio indicates how well the company was able to turn the assets into cash. It measures management’s ability to choose the right assets that have the potential to boost the company’s earnings.
The leverage ratio is the focus of this article. It shows how much of the assets were funded by debt. This ratio may not be readily apparent either. It is a bit abstract. But it makes sense when you think about it. Here is an explanation:
Let’s go back to your lemonade stand where the assets were funded 100% by equity. In this case, the leverage ratio will be equal to 1, with the value of the assets equaling the equity. That is, Assets = $100 and Equity = $100. This means that 100% of the purchase of the assets were funded using the equity in the company. No creditor has any claim to these assets.
Now, let’s discuss the debt scenario of your lemonade stand. Equity = $100, but the bank loan ($900) plus your equity ($100) funded $1000 worth of assets. It doesn’t matter how you bought those assets. The vendors you buy them from don’t care if you use the cash from a loan or from your own account. In fact, they won’t even know. How much will the leverage ratio be in this scenario? Asset / Equity = 1000 / 100 = 10. Debt has caused the leverage ratio to rise by 10 times in this case.
This means that when your company takes on a lot of debt, it has the potential to increase the ROE. In this scenario, leverage would multiply the ROE by 10.
If your profitability ratio follows suit and is higher and the efficiency ratio is higher as well, the impact the debt won’t be as problematic, mainly because the debt is serviceable. It means that the assets bought by the debt plus equity did a great job in earning money that was capable of paying down the debt. The company also made enough to pay for costs of the next business cycle. If the profitability and efficiency ratios don’t rise much after taking on this debt, that should be a warning sign that the debt will not be sustainable over the long run. More analysis is needed.
What confuses people about this concept is that the assets are paid for by money and what difference does it make where the money came from? In fact, I mentioned previously that vendors for those assets wouldn’t even know a loan was given. From their perspective, the business paid for their products with cash.
It all stems back to the right of first claims by creditors. Think about the loan you have for your home. If you defaulted on it, your mortgage company would foreclose on the home.
Some bank deals are structured such that no collateral or personal guarantees are committed to the loan. In this case, the bank would not necessarily have first rights to the assets. However, banks won’t readily make these types of deals except to well-established companies with solid credit profiles. For most small businesses, banks won’t consider such loans except for extraordinary circumstances.
The Short-Hand Version of the Equation
I stated that the ROE formula is as follows:
ROE = Net Income / Sales x Sales / Assets x Assets / Equity
How do we get to the short-hand version, which is:
Net Income / Equity
If you remember from your math classes, when the same number is in the numerator as it is in the denominator, you can turn that combo into a 1 as any number divided by itself is 1. Sales exists in both the numerator and denominator. Assets exists in both the numerator and denominator.
To put it another way, we could rewrite the equation as follows:
Net Income / Equity x Sales / Sales x Assets / Assets
The Sales / Sales = 1 and the Assets / Assets = 1. Therefore, the entire equation reduces to Net Income / Equity.
Is ROE Still Useful?
My analysis above may lead you to believe that ROE is a deceptive indicator and shouldn’t be used at all. That’s not the case, however. The indicator is useful, but you have to understand the meaning by peeling back the layers to make sure the companies you analyze are truly strong companies and not ones who will fail because they took on too much debt.
Another important point is that companies do increase their debt levels in the short run to get them through a cash cycle. Therefore, if you analyzed only one particular time period, you would be at risk of drawing the wrong conclusion. It’s best to view the ROE from a historical perspective, or as a comparison from one company versus another in the same industry.
The Return on Equity is an indicator worthy of inclusion in your financial analysis toolbox. It requires that you drill down to make sure you understand everything it tells you. It should also not be used as the only indicator when analyzing companies.