To-date, there are 900+ stocks listed on Bursa Malaysia. Question: ‘What is the most efficient method value investors use to shortlist growth stocks with great fundamental qualities from the others which are not?’
Answer: ‘Return on Equity (ROE)’.
It is a cheat sheet used by value investors to achieve greater returns from stock investing at significantly lower risks than others, particularly those who are just merely ‘trying their luck’ in the stock market. In other words, it is risky to invest in stocks without knowing and appreciating the power of ROE.
In this article, I’ll explain its definition, illustrate how you can use it, and explain why investors should calculate ROE of a stock before you invest. Thus, here are 5 things you should know about ROE before investing in stocks.
#1: ROE Definition
ROE is calculated as follows:
ROE = (Shareholders’ Earnings / Shareholders’ Equity) x 100%
Let me start with a simple example. For instance, you invested RM 10 million in a biscuit factory. You are its shareholder and the RM 10 million in capital would be your equity. Thus, your shareholders’ equity is RM 10 million, assuming that you are the sole owner of the biscuit factory.
In 2018, the biscuit factory has made RM 1 million in net profits or earnings. As such, the return on your shareholders’ equity is 10%.
ROE 2018 = (RM 1 million / RM 10 million) x 100%
This means, for every RM 100 invested, you have made RM 10 in earnings from your biscuit factory.
#2: ROE Application 1 – A Measure of Capital Efficiency (Part 1)
Let us say, we have two stocks: A Bhd and B Bhd. Both of them had made RM 1 million in shareholders’ earnings in 2018. Question: ‘Does it mean that they are equal in terms of their ability to deliver profits to their shareholders?’
Answer: ‘It depends on their amount of Shareholders’ Equity.’
For instance, if A Bhd has shareholders’ equity of RM 10 million, its ROE is 10%. If B Bhd has shareholders’ equity of RM 100 million, its ROE is 1%. In this case, I would conclude that A Bhd is more efficient in using capital to deliver profits as it took lesser capital (RM 10 million) to make RM 1 million in profits over B Bhd which delivers the same profits by using more capital (RM 100 million).
A Bhd’s ROE 2018 = (RM 1 million / RM 10 million) x 100% = 10%
B Bhd’s ROE 2018 = (RM 1 million / RM 100 million) x 100% = 1%
#2: ROE Application 1 – A Measure of Capital Efficiency (Part 2)
Let us move onto some real stocks. Which of the two stocks are more efficient with capital or shareholders’ equity? Is it Kuala Lumpur Kepong Bhd (KLK) or is it Panasonic Manufacturing Malaysia Bhd (PANAMY)? Here are their figures:
In 2018, KLK has generated RM 753.3 million in shareholders’ earnings. KLK has shareholders’ equity of RM 11,424.9 million.
In 2018, PANAMY has generated RM 131.0 million in shareholders’ earnings. Its shareholders’ equity is RM 881.7 million.
What’s your answer?
My answer is PANAMY because its ROE for 2018 is 14.86% which is higher than 6.59% achieved by KLK. For every RM 100 in shareholders’ equity, PANAMY has made RM 14.86 in earnings while KLK has made RM 6.59 in earnings in 2018. In this case, PANAMY was more efficient in using capital to generate profits when compared to KLK in 2018, despite making 5+ times more profits than PANAMY.
KLK’s ROE 2018
= (RM 753.3 million / RM 11,424.9 million) x 100% = 6.59%
PANAMY’s ROE 2018
= (RM 131.0 million / RM 881.7 million) x 100% = 14.86%
In other words, a stock may not be a better investment than another stock just because it is bigger in size and had bigger profits in terms of amount.
#4: ROE Application 2 – Reduce Investment Mistakes
Calculating ROE of a stock is an efficient method of reducing investment risks. I personally use it to avoid stocks that are of inferior quality. This is because ROE focuses on stocks that are, first and foremost, profitable. For instance, we have a stock: Subur Tiasa Holdings Bhd (SUBUR).
In 2018, SUBUR incurred RM 19.1 million in shareholders’ losses and has a total of RM 601.6 million in shareholders’ equity. Thus, its ROE 2018 is -3.18%, which means, it incurred a loss of RM 3.18 for every RM 100 in shareholders’ equity.
SUBUR’s ROE 2018
= (-RM 19.1 million / RM 601.6 million) x 100% = -3.18%
As mentioned, there are 900+ stocks listed on Bursa Malaysia. From this pool, I found quite a number of stocks which have both positive and well above 10+% in ROE. So, why do I need to take a chance on SUBUR when there are plenty of stocks which obviously have better ROE figures?
#5: ROE Application 3 – A Measure of Consistency
Here, let me share how you can perform the ‘10-Minute Test’ of a stock before putting it into your watch list.
Often, value investors may first compile a stock’s shareholders’ earnings and its shareholders’ equity figures for the last 10 years. Then, they would calculate its ROE figures for the 10-year period. Question: ‘Why 10 years, not 1 or 3 years?’
Answer: ‘Consistency. This is to check a stock’s track record of profitability both good and bad times, Ringgit up or down, oil price up or down, booms and busts and political uncertainties where all of these happened over the last 10 years. I find good stocks are those that generates consistent growth in profits, whether or not, market is good or bad. The bad ones could not. Therefore, this is a good test for a stock’s reliability in delivery of results to its shareholders.’
Let us use PANAMY as our case study. Its 10-Year ROE figures are as follows:
Return on Equity
Source: Annual Reports of PANAMY
From this 10-Minute Test alone, I can find out three things about a stock.
- Has it been growing profits consistently? For PANAMY – ‘Yes’
- Has it achieved above 10% in ROE consistently? For PANAMY – ‘Yes’
- What is the 10-Year ROE Average of PANAMY? 12.82% a year. It means that PANAMY has made, on average, RM 12.82 in annual earnings from every RM 100 in shareholders’ equity from 2009 to 2018.
Then, from this, you can perform the same 10-Minute Test on other stocks and compare it with PANAMY by asking the 3 questions stated above. If the stock is comparable with PANAMY, you may choose to keep it in your watch list. But, if it fails the 10-Minute Test, then, you may dismiss the stock as an investment.
Conclusion: Should I buy All Stocks with Above 10% in ROE?
No. The 10-Minute Test which involves calculating a stock’s ROE is meant to be a useful tool to identify good stocks from bad ones.
From the good ones, you may spend more time to study their business models, financial accounts, and evaluate its investment potential based on their current stock prices. You may invest in the good ones if their prices are reasonably low.
Happy Investing 2019!