Investors and lenders look at the Return on Equity (ROE) percentage from very different perspectives. Investors want to see as high a figure as possible as that will indicate what the management of the business is generating on their investment. However, for lenders, the same is not necessarily true. Say what? We don’t want to see a high ROE? Well, there are two reasons why this might not be a good thing. Let’s explain with two examples. First, a story about Pick ‘n Pay.
In Pick ’n Pay’s 2009 financial year, its return on equity (ROE) was an astonishing 132,7% (3 times that of rival Shoprite at that time) which underlined the company’s strategy at that time to focus on profitability and dividends to shareholders (and executive management) at the expense of investing in new technology, distribution etc.
While the company raked in the profits in the first 10 years of this millennium, its rivals, Shoprite and Woolworths, were steadily gaining market share in the two opposite ends of Pick ‘n Pay’s market. When the recession hit and consumer spending dived, Pick ‘n Pay was hardest hit because it wasn’t as efficient as its competitors which had invested in newer technology and improved distribution methods. Even now, after a few years of trailing its competitors, it’s still playing catchup to get back to the market leader it once was. So, a high ROE may just be a sign that a business is storing up trouble in the future with a short-sighted strategy.
The second reason a high ROE is not always a good sign is when the business uses high levels of debt to finance its assets. For this, let’s talk about a hypothetical example.
Say a business has 10m in assets and uses 8m in debt and 2m in equity to finance them. Let’s also say that the business makes 2m profit annually. Its ROE in this case is 100% (2m in profit divided by 2m in equity). So this looks great but what about the risk? Obviously the business is highly geared (its debt to equity ratio is 4) but the ROE ignores this because it’s not part of the calculation. We can see from this that we should never look at ratios or margins in isolation – always take a broad perspective to get the full picture.