It was interesting listening to “the Call” today when one of the viewers (Les, I think his name was) asked Mark Mooreland from Team Invest two questions about Return on Equity (ROE). The questions were saved up specifically for Mark

You would think that with the number of times Mark refers to ROE in justifying his calls that he would have been all over these questions. I’m sure Mark IS all over these and was just suffering a bad case of brain fog when put on the spot, as we all do from time to time.

I think Les would have come away completely confused after Marks response today. So if you’re here on Strawman Les, I hope this helps clarify your understanding:

Q1. What exactly is Return on Equity?

The formula for calculating ROE is simply NPAT/shareholder equity as a percentage.

You can’t use current ROE alone in evaluating the quality of a business. Other things to consider are:

• Debt - high debt on equity lifts ROE by using funds other than shareholder equity to produce the profits.
• ROE trends - falling share prices could be in response to the ROE trending down over time as the market is adjusting the historical PE ratio to reflect the falling quality of the business, and vice versa for a business with ROE trending up.
• Reported v Normalised Earnings - NPAT used in the ROE calculation is likely based on reported NPAT. In reality the normalised NPAT could be higher or lower than reported after taking into account abnormals and other things.
• Pay out ratio - A business that can reinvest a significant portion of its earnings at a high ROE further growing its equity and earnings over time is far more valuable than a business with the same high ROE that pays out all its earnings as dividends. When a business pays out all its earnings as dividends your return as a shareholder is the same as the dividend (including tax credits) regardless of the ROE.

Q2. How is high Return on Equity realised as the stock price is trending down?

The ROE of a business is not affected by the stock price. However, the stock price and PE ratio should follow the ROE over time. High PE is generally associated with businesses with consistently high ROE that can reinvest a significant portion of their earnings back into growth.

Ref: StockVal explanation