Does the ROE work for investing?

I am going to talk about one of the most used and popular indicators of fundamental analysis in the world.

Nothing less than the legendary Warren Buffett has said that this, the Return on Equity (ROE) is his favourite meter – it is said that he liked to invest in companies with more than 15% of ROE.

If the Oracle of Omaha says so then it will have to be important, right?

This ROE would come to give us a measurement of what we expect to obtain by the capital invested in a company, or in other words, the ability of the company to remunerate its shareholders.

It’s that simple

If the figure is high, it means that shareholders are receiving a good return on their capital, which should ideally be superior to other alternatives in the market.

The calculation formula is as follows:

ROE = Net profit after taxes / Own funds

Therefore, what a shareholder should expect is that in similar companies the best ones are the ones that have a higher ROE, and not simply more benefits.

As it is Warren Buffet’s favorite indicator, it is supposed to be one of the best for making medium and long term investments based on searching for “value”. That is, it is assumed that this meter would be giving us more information about those companies with value.

On the other hand, the ROE allows us to know how capital is being used in a company.

So, does the ROE work to make investment decisions?

It may well be that this meter is correct in most cases, but certainly not in all cases.

Also, for example, who tells you that Buffet did not use other metrics to combine with it when analyzing their investments?

Therefore, it is not certain that this indicator by itself keep the key to get the Philosopher’s Stone of the investment.

As always, the best thing in these cases would be to perform a quantitative study on your own, preferably with automation tools to see historical data of hundreds or thousands of companies and compare that ROE with the stock results of subsequent years.

Similarity of ROE and PE

This indicator is very compared to the PE, another favourite of the fundamental analysis and that many investors always use to compare their actions.

The PE as we all know, measures the price of the share for the net benefit that it has.

If, on the other hand, we divide the net profit by the price of that share, we would obtain the return that it gives us.

Well, in the ROE, what we do is remove the price of the stock for the book value of the equity of the same. With the ROE what we see is what we would actually be earning considering the money we actually use for the investment.

Well, as always, the best way is to see some example in situ. Better would be what I said before, that is, an in-depth study on the subject with professional tools and in dozens of different sectors, but here we will be enough with a sector chosen randomly right now and that will be the electrical ones, for which I will choose Endesa, Iberdrola, Gas Natural, EDF and ENI, to add two international companies but also listed in euros.

return on equity

Average 2011-2013Return 2014 a junio 2018 (%)
Gas Natural10.94-15.60

Well, first of all I have not included dividend yields so as not to lengthen the issue, but considering that they are all similar companies, I should not present really significant differences in the matter.

Well, that’s right, we can see that the companies with the highest ROE in the three-year average from 2011 to 2013 were ENI, then EDF and third Gas Natural.

According to the “Dogma” of the ROE, these companies would be the best to invest in that sector because they would be giving more performance to their shareholders so to speak, but the truth is that the three worst in the following four years of stock market were those three companies with a very bad result of EDF and one falls of 10 and 15% for the other two.

Interestingly, the two companies with least efficiency for the shareholder, Iberdrola and Endesa performed much better, to the point that the “worst” according to the ROE, Iberdrola, obtained a 58% return.

I promise that I did not look at this ex ante example, but I did it on the fly, at the same time that I wrote the article and that I took a sector at random, just like the day of the acid test I took the oil one.

From what we see the ROE theory has failed more than a shotgun fairs in this example.

This does not mean that this theory is not entirely valid to invest but we know with certainty that it will not be right in 100% of cases.

In addition we can already suspect that we can have a series of factors that would be important to consider.

For example, to me, to bounce soon, it occurs to me that in “expansive” stages of the economy, it is possible that companies that come to greater external financing resources, such as Iberdrola or Endesa, behave better, because they make better use of “leverage”, when there is “recovery”, but just the opposite could happen when facing a strong recession, since in this case the companies with the largest share of foreign resources would have to suffer greater consequences. As a curious fact I will wait to see what happens when the next recession in Europe, for which it may not be long.

Other possible failures in the investment model according to the ROE

There are some reasons for not trusting too much in the value of the book since it can be deceptive depending on the company we are in, as well as on the part of the cycle, too.

For example, what I mentioned earlier about the cycle is very important, because if we are in a super-expansive cycle of credit, those companies that will be heavily indebted and have a good business will be able to grow much faster than those that do not go into debt.

The danger for the first is not to reverse this situation of excessive indebtedness before the credit crunch arrives, at which time they are in danger of collapsing along with the rest of over-indebted entities.

Factors that can affect the ROE are:

  • A lot of cash in the box. If there is excessive it could cause a low ROE
  • Goodwill, which may be excessive or not and according to some experts can “inflate” own funds
  • Buybacks, because many companies do these operations and reduce own funds. Many analysts try to add recent buybacks
  • Amortization
  • Benefits after a long period of losses. In this case, the losses reduce the value of the book, which in the future can be deceptive that large yields are being obtained (when in reality it is not so)
  • Research and development expenses

Well, as you see, there are many factors that must be taken into account to perform a correct analysis with the ROE.

It seems that it is not simply to arrive and kiss the saint.

Moreover, I would say that we should probably include other variables and macro analysis of the economy, in order to try to draw conclusions a little more “complex” than simply saying: “X’s ROE is higher than that of its competitor Y, Ergo X is better to invest now. ”

Going back to the previous example, let’s see what ROEs these companies have in 2017, and I’m almost going to assume that in the next few years we will see a recession in Europe.

ROE 2017
Gas Natural9.08

Let’s see which the ones that behave better are.

Good trading.