Does high return on equity help investors multiply their wealth faster ?

The year 2020-2021 has not been kind to mankind. We all are struggling with the second wave of the corona virus pandemic and there is too much uncertainty. Yet, life moves on and we have to put our money to work for us. Every investor develops his or her own style of investing and this is what makes investing interesting and a continuous learning experience. If at all there was a simple and straight way to investing, we all would have followed that path to identify multi-baggers. However, one thing for sure that all investors would check for, irrespective of the investing style they adopt, is ‘return on equity’ ratio (ROE) or ‘return on net worth’ (RONW).

Both the ratios indicate returns generated over the owner’s capital employed or shareholder’s fund. Shareholder’s fund is defined as equity capital invested plus all reserve and surplus of the company. RONW measures profitability earned on the shareholder’s funds and is used as a benchmark for comparing one company with another and the company’s performance over the years. Change in RONW can be caused by a combination of any of the factors like change in the profit margins, capital turnover, financial cost ratio, financial structure ratio and lastly due to change in tax structure.

If we were to look at this ratio from an investor’s perspective, generally investors expect RONW should be growing or at the least be consistent over the years, and should be higher than the cost of capital. With this expectation in mind, investors would search for companies with higher reported RONW or ROE. In this article, we attempt to find out if companies with higher ROE tend to generate higher price returns in the coming years as compared to companies with lower ROE. In order to check this hypothesis, we have selected the top 1,000 companies on the basis of market capitalization as on April 2, 2021.

The companies which did not report ROE for the year 2020 were removed and thus we ended up with 953 companies. We started back-testing this data set from 2012 and made portfolios of companies on the basis of ROE, which gave us six portfolios: first one being the set of companies with ROE in excess of 40 per cent followed by a second set with companies having ROE in excess of 30 per cent but not more than 40 per cent, and so on.

In the year 2020, 641 companies had ROE in the range of 0-20 per cent and 168 companies had ROE of over 20 per cent, indicating that there are very few which are earning high ROE. Further, we obtained price return exactly one year from the date of investment. Starting from the year 2012, we divided all the companies and formed portfolios on the basis of ROE. The first portfolio was formed of companies with ROE in excess of 40 per cent. This portfolio was liquidated in 2013, the price appreciation of all the stocks was captured and average returns were obtained.

Now let’s analyse the values in Table 1. The best performing portfolio in terms of average price returns across all the years is highlighted and as can be observed, on seven out of nine occasions, a portfolio made of high ROE stocks (ROE greater than 30) has generated much higher average returns as compared to other portfolios. The average price returns generated by high ROE companies are also observed to be far in excess of the returns generated by the benchmark Nifty 50. However, in 2016 and 2017, it is observed that the high ROE stock portfolios have underperformed other portfolios but have outperformed the benchmark return.

"We can conclude that stocks which have high ROE have relatively done better than other stocks and hence they also have high average PB ratio".

Since the prices of small-cap stocks can sometimes change considerably in a short span of time, this can influence the averages. Hence, we used a valuation parameter of price to book ratio (PB) to confirm the understanding. PB ratio is calculated by dividing the price of the stock with the book value of the stock. A higher PB ratio indicates that the stock is overpriced in comparison to other stocks in the same industry. If a stock has a higher ROE and a high PB ratio in the following year it would indicate that an increase in price of the stock would lead to higher PB ratio. Since the book values of year 2021 are not available, we could not obtain the PB ratio for investments made in 2020 and held till 2021. Thus, the data analysed is for the period 2012-2020.

From Table 2 we can conclude that stocks which have high ROE have relatively done better than other stocks and hence they also have high average PB ratio. This supports our understanding from Table 1 that high ROE stocks would generate better returns for the shareholder. Now the big question is why do high ROE stocks perform better? As already discussed, ROE is an indicator of the profitability of a business in relation to the equity capital that is put to work in the business or in short, how efficiently the owner’s equity is used. So, intuitively, companies with consistent high ROE ratio would enjoy some kind of competitive advantage or could likely be utilising more debt than equity to fund their operations.

Since the earnings’ season has just started and companies like TCS, Infosys, etc. have started reporting their annual results for the year ending 2021, investors who can track results should always watch out for companies with high governance standard, growth prospects and high ROE to maximise returns.

All said, we recommend that no single metric or ratio should be used to make an investment decision. There is no substitute to thorough fundamental analysis and one should understand his own risk profile before investing.

Dr. Ruzbeh Bodhanwala and Dr. Shernaz Bodhanwala, faculty at FLAME University, Pune