Return on Equity (ROE) – Is It the ‘Magic Number’ of Share Picking Tools?

Although some share market skeptics claim most share picking tools yield results no better than throwing darts at a wall, there are numbers any investor can look at to help pick solid investments.   Return on Equity (ROE) is one such number.  Simply put, ROE measures how well a company makes use of the money its shareholders have contributed to the business.   Here is how you calculate ROE:

NET INCOME / SHAREHOLDER EQUITY

Shareholder equity is the difference between the total assets of the business and its total liabilities.  This ratio yields a percentage figure that tells an investor how well the company makes use of what it has.  The higher the ROE the better the company is at providing returns to its investors and owners – the equity holders.  Since getting a better return for your money through share investing versus alternative investment vehicles is what it’s all about, is ROE the “magic number” that tells you what shares to pick and which ones to avoid?

To answer that question let us look at the ROE for one of the crown jewels of the Australian economy – BHP Billiton.

The Internet has made it much easier for investors to analyse companies, as there are now financial websites where these numbers are calculated for you.  You no longer have to dig through the company financial statements on your own.  Using MSN Money we find BHP’s most recent ROE is 28.8%. What does that mean?

First, you have to know in some cases “appearances” can be deceiving, depending on what went into the calculations.  Accounting issues that are unique to a given period of time can make the number look better than it actually is.  Stock buy backs and one time accounting write offs can inflate the ROE making a less useful tool.  To account for that, many investors prefer to look at a 5 Year average ROE.  For BHP the 5 Year Average ROE is an impressive 35%.

Most financial analysts would say an ROE anywhere between 15% and 20% represents an excellent investment, so is this number alone all you need to know to determine that shares of BHP are the best investment you can make?

A simple mental model to use when thinking of share market investing is that of boats on a body of water.  No one evaluates a boat based on its performance in dry dock.  A potential boat purchaser needs to know not only how well an individual boat performs on the open water, but also how it compares to the performance of other boats.  Boat A may seem like a very good value for your dollar until you compare it to Boat B.  Think of the water as the global financial markets and the boats as individual companies operating within those waters. 

Numbers like an ROE do not exist in isolation.  To extract the full measure of their meaning you have to have a valid basis of comparison.  How does BHP do compared to its competition – to the other boats on the water?  Here is a simple table comparing BHP’s ROE performance to other companies in its industry:

This table serves to make an investment in BHP shares seem even more attractive.  The 5 Year Average smoothes out inconsistencies in unique conditions in accounting periods and the industry numbers indicate that BHP performs better than other similar boats on the water.   On average, this is true but when it comes to making investment decisions the comparison is useless.  Why?  You cannot always buy shares in the “industry” in question.  You have to buy shares of specific companies within the industry.  It is entirely possible there are companies buried in the Industry average that perform better than BHP.

Check the Internet for BHP’s major competitors and you will find VALE and RIO (Rio Tinto) on every list.  Again, we return to our central question – is ROE a single indicator that you can use to make an investment decision.  The following table includes all 3 of these mining giants, with ROE industry wide comparisons.

Can this table taken alone tell you which of the 3 companies is the best buy?  The first thing we can learn is the difficulty of making direct comparisons of companies that operate in multiple sectors.  Note that the industry comparisons for Vale and Rio are different from BHP.  Because it operates in so many different sectors, BHP is categorized as an Industrial Metals and Minerals company while Vale and Rio are considered part of the Steel and Iron industry.

This does not mean you need to sort through the BHP financial report to find the related sectors that could allow a direct comparison.  The point is there is no single indicator, no “magic number” on which you can draw to make an investment decision. 

If ROE were such a number, when faced with a choice of investing in VALE versus BHP no one would choose VALE.  However, looking at some other profitability indicators changes the picture. 

Using an analysis tool like MSN Money’s research wizard shows that for the last 12 months VALE had both higher sales growth (78.8% versus 5%) and higher income growth (206.1% versus 116.5%) than BHP.  In addition, VALE posted a higher net profit margin – 33.69% versus 24.64%.

In summary, while Return on Equity is one of the best indicators available of a company’s performance and growth prospects, it cannot be taken in isolation.  The inconvenient truth is that share picking is an involved and often arduous prospect that must consider many factors.  If you are looking for a single magic number to guide your investment decisions, you are in the wrong market.  Try Term Deposits.