Saturday, June 23, 2007

Return on Equity, Episode II (ROE-EP2): A company’s organic growth rate

ROE can also be used to gauge a company’s organic growth rate. This means how fast the company can grow without relying on external factors like M&A, gahmen support, tax relief, Toto winfall, father mother sponsorship or anything else other than its own profits.

Remember that Net Profit, though a volatile no. due to multiple manipulation from sales, to operating costs, to interest and tax, does measure the profit that should go to shareholders if the accounting is done with integrity. And Net Profit is actually added to Shareholders’ Equity at the end of the year.

So Return on Equity or ROE which is

Net Profit / Shareholders’ Equity

tells you how the growth rate of shareholders’ equity has been, in the past 1 year. Now if past ROE is a good gauge for future ROE, we can then assume that next year’s Shareholder Equity will grow exactly by its ROE right? Savvy huh! This is the critical part, usually, high ROE will not last into the future bcos things always mean revert. But if you tracked this particular Co. which had ROE of 20% for the past 20 yrs, then maybe you can quite safely assume next year it will be 20% as well. Btw, ROE of 15-20% is sort of a long term average that things mean revert to. If the Co. has like ROE of 50%, then probably it will mean revert to 20% after some time.

Ok, analogy time. Say Co. X has a ROE of 20% for the past 20 yrs and shareholders’ equity of $100 at the end of Year 20. Since ROE has been 20% for donkey years, we can assume that it is also 20% in Year 21. And Voila, it IS 20% and Co. X earns $20 in net profit. Assuming the Co. X pays no dividend, this $20 is then added back to shareholders’ equity at the end of Year 21 and so Co. X shareholders’ equity becomes $120. In Year 22, Co X again earns 20% of $120 in net profit which will again be added back to its shareholders’ equity and become $144. Shiok huh!

So as you can see, ROE measures the growth rate of the company’s shareholders’ equity if the company does not distribute out net profits as dividends. (If it does, the growth rate simply becomes ROE x (1 – payout ratio), where payout ratio is between 0-100%.)

So when a company has an ROE of 20% and can maintain that, it means that the company can grow its equity base organically by 20% every year (i.e. without relying on M&A etc). Sounds attractive right? This is another reason why people look at ROE so much.

PS: Shareholders’ equity can grow by 20% per year doesn’t mean that stock price will also grow by 20% per year, There is difference between performance of the company and the performance of the stock!

See also ROE Part I

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