by elmads

Introduction

All endeavours that relates to committing money with the expectation of it to grow in the future is called investing. Either, it’ll be for starting our own business, or just exchanging money for an asset that we deem will appreciate overtime.

The question here is, how will we know our return in our investment? This is where percentages trumps the monetary value. Most individuals will always focus in the monetary amount return, which is understandable because that’s the first and foremost reason why most of us are investing, but the skill of being a good capital allocator and compounder of wealth is based on percentage returns.

That being said, possessing both earnings power (having to invest larger amounts of capital) and also being a skilled compounder of wealth is the ultimate goal in investing. Usually, the former is easier done than the latter.

The simplest way to compute for our year end increase/decrease of our investment return is through the formula below:

Return on Investments = ((Final amount of your investment – Initial Capital Invested) / Initial Capital Invested) x 100.

Let’s say you invested $100 today on a share of Company XYZ, then after a year it increased to $180.

Return on Investments = (($180-$100)/$100)*100

  = ($80/$100) * 100

  = 0.80 * 100

Return on Investments = 80%

This means you made an 80% increase for that year, but that’s only based on your initial $100 that you’ve invested. There are some people who will further compare their whole investment returns to their total net worth. Why? because it shows how efficient they are with their investments, how well they can generate their investment returns relative to their net worth.

Personal Finance – Return on Net Worth

This asks the question, how efficient are we in generating investment returns with our own Net Worth? The higher the percentage per year, the better.

For us to be able to get our own RoNW, we first need to calculate our own Net worth. To do this, we need to list and document all of our assets and liabilities, then subtract our total assets to our total liabilities. I have discussed this in detail in my blog titled “Financial Mutant Level of Managing our Money – Our own Net Worth”.

We need to divide our total year end investment return to our Total Net Worth. The result will then be our Return on Net Worth (RoNW).

Formula:

Return on Net Worth = Realized/Unrealized gains for the year / Our Total Net worth at the end of the year.

A good Return on Net Worth should first and foremost be a positive percentage. Because having a negative RoNW means that your total liabilities exceeds your total asset, hence a Negative Net Worth. An individual usually has negative Net worth due to debt. See example below:

Nevertheless, if your RoNW is negative due to a mortgage loan, that’s understandable because most people will take on a loan to be able to buy a home.

Furthermore, If your Net Worth is still in the negative territory despite not having any mortgage loan in your name, then you should investigate and dig deeper into your expenses, debt and budgeting strategies. This signifies that, there’s a hole in your ship that could cause for it to go underwater in the long haul.

A negative net worth is also expected happen almost everyone, most especially for individuals who just started to enter the workforce, the 20s to 30s age group.

Second, a good RoNW will be more than the year’s inflation rate of your country.

Lastly, a great RoNW should be more than 10% a year. (This is my personal choice)

To review again, a good RoNW should have the following;

1.) Positive RoNW. If it’s negative due to a mortgage loan, that’s normal. Also, A person who starts his/her financial journey will always start with a negative net worth, except for the ones who had support via their family’s wealth.

2.) RoNW should supersede Inflation.

3.) RoNW of more than 10% annually.

This is for personal finance, but what if we bring this concept to investing? By analysing companies and valuing it, we would no longer be calling it as RoNW anymore. Instead, we now call it as Return on Equity (ROE).

Fundamental Analysis – Return on Equity

ROE has similarities with RoNW. The latter is for personal finance, while the former for analysing a business. Companies have their own Net Worth as well, and it’s called Equity.

For us to arrive into a company’s equity, we need to subtract their total assets to their total liabilities. It is exactly the same on how we compute our individual net worth.

Return On Equity is a measure of a company’s financial performance, their efficiency on generating income with the equity they have.

Formula:

Return on Equity = Net Income / Equity

We’ll use Google’s 2021 financial statement report as our examples.

Link for their 2021 Annual Financial Statement Report–> Google’s 2021 Annual Report Link

• Google’s 2021 Net Income = $76,033
• Google’s 2021 Total Equity = $251,635

Google’s 2021 ROE = $76,033 / $251,635

Google’s 2021 ROE = 30.22%

Google was able to generate an income which is 30.22% of its total equity in 2021. To show if this percentage is a good enough return on equity, we’ll need to do a benchmark. And this is by doing a relative comparison, either via the broader market or by industry.

1.) It should be higher than the long-term S&P 500 companies’ average ROE, which averages around 14%.

2.) The other method is by comparing the company’s ROE to its industry’s ROE. As Google is an advertising company, we could then compare its ROE with the US Advertising Industry.

Doing both methods will give us an insight if the company we are analysing has better financial performance, in ROE terms, relative to to its other competitors within the same industry or the broader market.

Warren Buffett, known as the Oracle of Omaha due to his stellar long-term investment returns of 20% annually since 1965, always looks into a company’s Return on Equity. He stated that he likes companies who can generate more than 10% of their Equity per year in net income.

Nevertheless, ROE has its flaws, just like any other fundamental analysis metrics.

Return on Equity – Always look under the hood

1.) Profit Fluctuations – A fluctuating profit year on year will show a volatile historical ROE of a company, because profit is the numerator of the ROE equation (ROE=Net Income/Equity).

Fluctuating net income can indicate a lot of things, such as large non-core business profit/loss, cyclical nature of the company (e.g., consumer discretionary and property businesses), competition (market share), and management’s ability/inability to scale the business to name a few.

A sudden spike in ROE doesn’t mean that the company will be having the same high ROE for the succeeding fiscal years. Any sudden increase in ROE in a certain year can be due to one off income increases, and such things happen when a business sells a large piece of a company’s assets like property, land, or equipment. Divestment of another portion of a business is also a one off income increase, which is not directly tied to the main core business operation of the company. Also, a sudden decrease in ROE has its own story as well, and investors need to find out what caused such changes.

Below is a photograph that show two different businesses and their respective historical Net Income and ROE from 2007-2022. The top portion of the photograph shows both a column and line graph of Tate & Lyle plc (ticker: TATE, a British-headquartered global supplier of food and beverage ingredients to industrial markets), while the bottom is for Alphabet Inc (ticker: GOOG).

The financials of a business always tell us a story.

2.) Profit Loss – If a company produces a negative income, which can be due to various factors such as operational business problems, competition or economic conditions. Then the ROE of a company would be on the negative territory because of the profit loss. If you divide a negative number (negative profit) to a positive number (positive equity), the result will always be negative.

But what if the company suddenly turns a profit the year after? what will happen to its ROE? There are actually two things that could happen;

Firstly, the company’s Equity could decrease because of its previous profit loss. Why? if a company doesn’t generate an income in a certain year, where do you think they will get the money to continue to operate their business? It’s either, they’ll tap into their accumulated business savings via their cash reserves, raise capital through debt financing, and/or equity financing, or do all of the three. This will depend on the corporation’s management. In most cases, corporations tap into their cash reserves, or sell some of their current assets. They’ll use their accumulated cash to sustain and continue their business operations up until they become profitable.

In an individual level, it’s tapping into our savings when we do not have any income for a period of time due to a certain unexpected event in our lives. (Emergency & Rainy Day Funds)

Secondly, due to the decrease in equity of the company, then the sudden profitability after a year will give an impression of a massive increase of ROE. At face value, most people would think that the business did a great job because of the sudden jump of its ROE, but underneath the hood, it’s a different story. Do you remember the ROE formula? = Net Income/ Equity. Think of it as like this;

Year 1 : Negative ROE due to = Negative income/ Positive Equity
Example numbers below:
ROE= -1/5
ROE -20%
Then the company used their cash reserves to continue to operate their business for the succeeding years, up until they become profitable. This will cause for their Equity to decrease from 5 to 4 (Only an example)

Year 2: They’re now profitable, with Positive High ROE
ROE = 1/4
ROE = 25%
Due to the decrease in Equity, while the company became profitable at year 2. This gives an immediate impression of a great job for the management, when in fact the denominator just shrunk giving its income a lower base to divide with.

Sometimes, there will be instances that the ROE of a company will be consistently more than 15% and you’ll be thinking that this is a good business to own, as it generates an income more than 15% of its equity. But when you look deeper into its financial statements, it tells a different story. Like what story? like the photograph below.

Having a business owner mindset, you would ask this question. Which one of the three scenarios above would you prefer to own?

A good and consistent high ROE of more than 10%, must accompanied by increasing or maintained Income and Equity of the business. Overall, this indicates growth of the company.

We always need to look under the hood of a company’s financial statements.

3.) Debt – Debt can help a company but also destroy them. A good way to know if the debt level of a company is manageable or not, is through analysing some of their liquidity and debt ratio metrics such as debt-to-equity and current ratio to name a few. I’ve discussed these in my 2 part blog series titled “Fundamental Analysis – Liquidity & Debt Metrics – Part 1″ & “Part 2”.

The problems with having a lot of debt with corporations, other than the risk of default and financial squeeze, is the risk of a negative total equity of the company. Remember that Equity = Total Assets MINUS Total Liabilities. A company acquiring a lot of debt will most likely increase its liabilities portion, but when the liabilities side of the balance sheet increases more than the growth of its assets, a drag down of the total equity of the business may occur or worse a negative equity.

For example:

Year 1

• Total Assets = 1,000                            
• Total Liabilities = 500
• Equity = 500

Year 2

• Total Assets (increased) = 1,600                            
• Total Liabilities (increased) = 2,000
• Equity = (-400)

As you can see in the example above, both assets & liabilities increased from 2020 to 2021, but the increase of its liabilities superseded the growth of its assets. Henceforth, a negative equity.

These things happen not just with individuals but also businesses. What I’ll show you below is the balance sheet of the top fast food chain in the world, McDonald’s Corporation.

McDonald’s has always been a profitable company. Unfortunately, their ROE has been negative since 2016 due to their negative equity.

With McDonalds having a negative equity, can we then say that the company is a bad investment? Absolutely not, remember one metric alone must not be the basis of our investment decision.

In McDonald’s case, I don’t know if they’re a wonderful, fair enough or bad business to own as I have not looked into their past to current financial statements, how they operate their business and its management. Sure, they have a monumental amount of debt, which is an automatic disregard business for me. Then again, I don’t know the story how they used that debt, where did they use it, and how much monetary and percentage returns those debts made for them. There is and will always be, a lot of things to look first before making an investment decision.

We own businesses, not ticker symbols.

To sum it up

Return on Equity is an important metric in fundamental analysis because it shows a company’s financial performance and their efficiency in using their equity to generate income. Yet, this is only one side of the financial story, as this doesn’t show the full narrative of what happened in a company within a certain fiscal year and past years. This is why digging deeper, reading the company’s annual reports (past & present), looking into what the management has had said, their plans for the future and the risks they face are important. This gives the financial data colour and life for investors, which will significantly help us to arrive into our own personal investment decision based on what we have read, and analysed.

Investing is making an informed decisions based on the available data we can acquire directly from the source (financial reports). We do this in order to lessen the risk of permanent capital loss and also open our eyes to the opportunities that we never knew existed before.

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.