Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 126

How are the returns on your equity?

Through the volatility of recent weeks, the adverse impact on the market value of our portfolios has been minimised by a focus on high quality businesses, a margin of safety in the difference between price and valuation, and the ability to hold large amounts of cash when opportunities are unavailable. An extraordinary business must have bright prospects for sales and profits, a high rate of return on equity - driven by sustainable competitive advantages, solid cash flow, little or no debt - and be run by first-class managers who think like owners and treat their shareholders as such.

A good business to own is one that produces growing profits. That seems obvious. Indeed it’s what the vast majority of analysts and equity investors are looking for.

What is the ideal business to own?

Perhaps less obvious is that the best business also requires the least amount of capital invested in it to generate those profits. There is a yawning chasm in the worth of a business that grows and requires lots of additional capital, and the business that grows and doesn’t need any additional capital.

A perfect business might be one that requires no staff and thus has no labour costs; no machinery and so does not require any equipment to be maintained or replaced; and no inventory, so there’s no need for trucks, warehouses or stock management systems and no chance that you will be left holding products that are obsolete or out of fashion. When these things are required by a business, there is less cash to distribute to investors or less cash available to be invested elsewhere. First prize is a business that generates high returns with all of those profits available to be distributed or reinvested as the owner sees fit.

Importance of ‘return on equity’

Perhaps the single most important factor in the identification of a wonderful business is a number, a simple ratio, the return on equity. That is, the level of net income as a percentage of shareholders’ equity. The actress Mae West once said, “Too much of a good thing is wonderful”, and return on equity is like that. It is a measure of the earning power of a business and while accounting focuses on providing an estimate of the business’s performance and position, the economics reveals the true picture.

The wealthiest man alive today, Warren Buffett, is an enormous fan of return on equity as demonstrated by the statements: “Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe [a more appropriate measure] of managerial economic performance to be return on equity capital.” And: “The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”

The return on equity ratio tells us many things. First, it is a measure of the quality of a company’s business. Many people wrongly believe that strong growth in profits over the years is an indication of a superior business. It isn’t. Companies like ABC Learning displayed strong growth in earnings yet still collapsed. ABC Learning had low and falling returns on equity. Economic returns, as measured by return on equity, are a better indication of business quality than earnings growth. Return on equity helps tell us which companies display ‘good’ growth. It sorts the wheat from the chaff. A company with strong earnings growth prospects and high rates of return on equity is the sort of business in which you should buy shares.

Using ABC Learning as an example, the company’s reported profits revealed spectacular growth, and it was not unusual for sell-side analysts to slap ‘strong buy’ recommendations on the shares. But ABC Learning’s earnings were growing because more and more money was being tipped into the company by shareholders. You can get more earnings each year if you tip money into a regular bank account. There is nothing special about that. Because the company was asking shareholders for money to help it ‘grow’, the profits coming out of the business, when compared to the money going into it, showed the returns from the business were declining, as Chart 1 displays.

Chart 1. ABC Learning’s Declining Returns on Equity

RM Figure1 110915

RM Figure1 110915

By 2006, the returns on the nearly $2 billion that shareholders had stumped up were about 5%. This was even less than the returns available from a bank term deposit at the time, which harbours a lot less risk than a listed business.

Would you put $2 billion of your money into a business if I told you that the best you could expect was 5%? Of course you wouldn’t. And if you aren’t prepared to own the whole business, you shouldn’t be prepared to own even a few shares. The stock market can sometimes be a slow learner, and while share prices tend to follow returns on equity rather than the earnings, it can take a long time. So in 2006 there was plenty of warning.

Second, high rates of return on equity can also suggest sound management, although a great managerial record is often the result of the boat the managers get into – the existing quality of the business. Indeed, high returns on equity are more likely to be the result of a great business than great management. Some excellent businesses may have a combination of both - a wonderful vessel and a great skipper.

Third, high returns on equity may be an indication that the business is operating as a monopoly or in an industry with high barriers to entry. Something unique that prevents others from competing directly or successfully with the business is known as a sustainable competitive advantage.

Fourth, the return on equity can also tell us whether the company should reinvest its profits or pay the earnings out as a dividend. Because this decision is made by management and the company’s board of directors, return on equity can help show us which teams understand how to allocate capital properly, and therefore those that treat their shareholders like owners.

Fifth, return on equity can tell us something about whether the auditors and the board of directors are realistic when it comes to what they think their assets are worth. If the return on equity is consistently very low, it may suggest that the assets on the balance sheet are being valued artificially high. Investors lose millions when companies announce write-downs, and write-downs usually follow a period of low returns on equity - for example, after the company paid too much for an acquisition and the promised ‘synergies’ failed to materialise. If a company makes a big acquisition and projected returns on equity are low, it’s usually wise to sell your shares.

Finally, return on equity is an essential ingredient in establishing the true worth of a company and its shares. Ultimately, investing is about buying something for less than it is worth. Do this consistently, over a long period of time, and you will beat the market and the majority of other investors. And at the heart of working out what a company is truly worth is the return on equity ratio.

Return on equity can tell us much, and it is a very powerful ratio essential for success in the stock market.

 

Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able’. This article is for general educational purposes and does not consider the specific needs of any investor.

RELATED ARTICLES

Invest in Australian value stocks before it is too late

Global search for short-term losers and long-term winners

High growth and low rates incompatible with current share prices

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.