Return on equity is often used by investors as a shortcut to determine a company's quality. The figure provides a gauge of how profitable a business is compared to the amount of cash invested, although like most metrics that are designed to produce a simple solution to a complex question, it has its downfalls. The biggest problem with the figure is that it can be manipulated quite easily by using different accounting methods.
The problems with return on equity
Return on equity is essentially profits compared to the amount of money invested in the business as defined by equity. Equity, or shareholders' equity, is calculated as assets minus liabilities.
The biggest problem with this figure is that liabilities include debt, and the higher the debt figure, the lower the shareholder equity figure will be. Therefore, a company with a high amount of borrowing might produce a high return on equity figure, even though it is relatively unproductive compared to the rest of the industry.
What’s more, while equity might tell us the business's overall health, it does not really tell us anything about the underlying assets that support the enterprise. Let’s say a company has $100 in assets and $90 in liabilities. That would give a shareholder equity figure of $10. Based on this metric, the company looks financially stable. But if the company’s assets are virtually all goodwill and intangible assets, and all the liabilities are debts falling due in the next two years, the situation is much more challenging to decipher.
These are just the problems with the equity side of the return on equity calculation. They exclude any accounting shenanigans that may influence the return side of the calculation. It is very easy to manipulate income figures in a way that flatters a company.
Dealing with the drawbacks
So, how do investors get around these issues? Well, I think the first step is to acknowledge that there will never be a simple metric one can use to try and decipher the quality of a business.
Every business has its own benefits, advantages, strengths and weaknesses. It requires in-depth research and an understanding of the business and its market to know where these strengths lie and how it compares to the rest of the industry.
Second, rather than focusing on return on equity in isolation, we should be looking at multiple metrics such as free cash flow and cash conversion. These metrics will give us an idea of how much the business relies on accounting techniques to flatter its bottom line. It will also give us insight into how sustainable income generation is and how sustainable return on equity can be over the long term.
Third, investors need to consider the quality of a company's balance sheet rather than try and estimate its productivity using a simple metric. A highly indebted business might not look like a top investment at first. Still, if the business has borrowed vast sums at near-zero rates of interest on multi-decade time horizons, this could actually be quite a smart bet if it has been making good use of those borrowed funds. In fact, I would prefer investing in a business like this than a company with a clean balance sheet full of intangible assets and goodwill that is seeing its bottom line decline.
Every single business is different, and this is why it is so hard to pick the best companies as an investor. We need to understand what makes companies tick, how they earn their money and the sustainability of their income streams.
This knowledge only comes as a result of research, and in many respects, it is far more critical to know these factors than to establish whether or not a business has a higher return on equity.
