One metric to rule them all: The power of ROE in gauging stocks

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How can a business create real value over the long term? Today we focus on measuring value creation through the magic of return on equity (ROE).

In the short term, sentiment can boost the price the market is willing to pay for a given set of earnings, but long term, without a demonstrated track record of being able to grow those earnings, a company’s – and a stock’s – performance will go nowhere.

How can you tell whether a businesses has what it takes to create real value, consistently, over time?

At its core, it’s about generating consistent, sustainable earnings growth from the cumulative value that’s been created in the company so far:

Return on Equity = Net Income / Average Shareholders’ Equity

In this equation:

Net income is the bottom-line profit that a business earns after paying everyone, including its staff, its suppliers, its landlords, its lenders and so on; and

Shareholders’ Equity is a measure of all the money put into the firm plus the money retained in the firm. (For the formula, Average Shareholders’ Equity is just an average of the equity and the previous period’s equity.) Shareholders’ Equity includes:

• Cash that was put into the company by the founders and investors in subsequent share issues; and
• Money that was retained within the business over time – i.e., the profits less any dividends paid out to shareholders.

So, essentially, ROE answers the question: How much did you grow earnings this period in comparison to what you had to work with?

Margin growth

A central element of ROE is the profit margin a company is able to generate. Net profit margin denotes how well a company can turn sales into earnings.

“Margin growth is in my experience the driver of equity returns,” says Dave Jiles, who heads up the equity team at Leith Wheeler Investment Counsel, an independent wealth management firm with offices in Vancouver, Calgary and Toronto.

“If you have growing margins that are sustainable, the stock will follow.”

He points to Caterpillar dealer Toromont Industries Ltd. as an example (see Figures 1 and 2). It has demonstrated an ability to grow its margins and generate high ROE and stock price returns.

Common attributes among companies able to do this well include disciplined cost containment, a competitive advantage that gives them pricing power, rational industry players, economies of scale that enable them to lower unit costs, and a shrewd ability to deploy capital profitably.

Capital deployment

“One of the key components to high ROE and Return on Invested Capital is the ability to deploy capital,” says Richard Liley, also a portfolio manager with Leith Wheeler. “The companies that really create value reinvest their cash into the business.” (Return on Invested Capital (ROIC) is similar to ROE but measures the return on the investment by both shareholders and debtholders in a company.)

Constellation Software Inc. is an example of a company whose management team has a superb track record of doing just that (See Figures 3 and 4). The company’s business model is to buy private software companies and consolidate them. Doing this well – not only identifying quality companies and paying a fair price, but then giving them an environment to continue thriving after they’ve been acquired – is difficult, but Constellation has proven its merit time and again. Shareholders who bought on the IPO in 2006 have seen their investment increase by over 19,000% since then, or about 35% per year.

Canadian banks often get an honourable mention in a conversation about ROE because they tend to reliably deliver ROEs in the mid-teens. But banks are not without constraints. Given their dominance in everything from banking to capital markets to asset management to insurance, Canadian banks can quite simply struggle to find new ways to invest in the Canadian market.

“Forty to 50 per cent of the cash they generate is paid out as dividends,” Liley says, because the market is so mature and saturated. “You can’t really force people to take out loans.”

The only logical alternative then is for the Canadian banks to go global in their ambitions, which they’ve all done to varying degrees (and with varying levels of success). Scotiabank, for example, has paid out the biggest percentage of its earnings as dividends (and so, retained the least for its business). Together with some mixed results from the bank’s push into Latin America, it has generated the worst results of its peers in recent years.

Shareholder-friendly financing

One important lever that affects a company’s ROE is the Shareholders’ Equity part of the equation.

Companies have three main ways to finance themselves over time. There is no one good answer to what is best in any circumstance, but the following things can happen when you use each one:

Financing through the cash flow generated within the business: The gold standard. Earning and reinvesting cash flows within the business is great as long as the projects you are funding generate sufficient return.

Financing by borrowing money from the bank or the bond market: There is an optimal level of debt for any company that balances the benefits of lower-cost financing and ROE-boosting preservation of the shareholder base, with the incremental risk of going bankrupt. This is the double-edged sword of leverage.

Financing by selling new stock (equity issuance): If you issue stock to finance mediocre projects, you will slowly erode the value of your shares by diluting (reducing) earnings per share and lower ROE. See Magna example below.

It’s easy to look at a bond issue and say, “That $100 million bond issue is costing the company 7 per cent interest, so $7 million per year before tax.” But what is the cost of raising that $100 million by issuing new shares?

I think of it this way: If new guests showed up to dinner, how much does the (earnings) pie have to grow so your piece doesn’t have to shrink? In practical terms, management teams often invite new guests to dinner (issue stock) to fund projects, but do the new projects pay off enough so everyone – old and new shareholders – ends up richer?

About 20 years ago I covered the auto parts manufacturer and assembler Magna International Inc. (a stock Leith Wheeler has not owned). After getting into some hot water by overleveraging and almost losing the company in the 1990s, founder Frank Stronach opted to issue stock frequently thereafter. He preferred to sell off pieces of the company rather than flirt with bankruptcy again. The good news is Stronach did a lot of good things operationally, but all those extra shares out there meant the long-term shareholders kept getting their pie slices trimmed.

Figure 5 shows Magna’s net income versus its earnings per share (EPS) and share price over that 10- to 15-year period. As you can see, earnings grew (great!), but EPS – and, as a result, its share price – grew far slower (less great). This chart shows that for investors, EPS is what ultimately matters.

Conclusion

Our analysts agree on this: Companies that focus on growing margins, deploy their capital wisely and prioritize EPS growth are well positioned for attractive ROE, and this will, over time, deliver greater value for shareholders.

Mike Wallberg, CFA MJ, is Principal, VP Marketing, for Leith Wheeler Investment Counsel, one of Canada’s largest independent wealth managers. With offices in Vancouver, Calgary and Toronto, Leith Wheeler manages more than $23 billion for individuals, families, foundations, Indigenous communities and institutional clients across Canada. A former investment banker, equity analyst, institutional portfolio manager and television news producer, Mike also hosts CFA Institute’s flagship investment podcast, Guiding Assets, which is currently ranked in the top 10 per cent of business podcasts globally.

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