Opinions on using Return on Equity as a company valuation parameter

[TheMotorcycleBoy]

Evening all,

So we have been recently looking at calculations for ROCE and FCF in order to derive estimates of the worth/strength of a company. What merit is there to calculation of "return on equity" i.e.

ROE = Net Income / Shareholder’s Equity

?

What kind of firms is ROE a good or bad measurement parameter, and are there certain types of firm where ROCE is a better or worse measure and so on?

And furthermore if one is designing a kind of traffic light system for the parameters on a company valuation spreadsheet, what kind of value for ROE would usually mean, "if less that x% stay away", and likewise what typical values between x% to y% would mean "possibly consider provided such-and-such criteria are met", and of course what value of z% implies "this firm is an absolute belter using this valuation parameter" etc?

thanks
M&M and apologies for yet another wall of questions!

[westmoreland]

Evening all,

So we have been recently looking at calculations for ROCE and FCF in order to derive estimates of the worth/strength of a company. What merit is there to calculation of "return on equity" i.e.

ROE = Net Income / Shareholder’s Equity

?

What kind of firms is ROE a good or bad measurement parameter, and are there certain types of firm where ROCE is a better or worse measure and so on?

And furthermore if one is designing a kind of traffic light system for the parameters on a company valuation spreadsheet, what kind of value for ROE would usually mean, "if less that x% stay away", and likewise what typical values between x% to y% would mean "possibly consider provided such-and-such criteria are met", and of course what value of z% implies "this firm is an absolute belter using this valuation parameter" etc?

thanks
M&M and apologies for yet another wall of questions!

ROE is useless because companies may have low or negative equity. e.g. company has £100m equity, and buys back £150m of stock, putting the company in negative £50m of equity. this now renders the ROE useless.

ROCE is almost always the measure to use. the only time it is not the best measure is when a company deploys very little capital, rendering the return on capital unhelpful. right move has something like a 2000% ROCE, but cannot deploy large amounts of capital at this rate. in other words there is something else at play.

to calculate ROCE properly, you must also capitalise leases.

ROCE must be at least 10% to invest IMO. anything above 20% is outstanding, but not so attractive if there aren't opportunities to deploy lots of capital at similar rates. below 10%, and the business isn't really creating value for shareholders.

[TheMotorcycleBoy]

Today is our 20th wedding anniversary

So full replies are delayed!

M&M

[Dod101]

ROE is the measure usually used by financial companies, banks, insurers and the like; ROCE for most others.

The ROE figure is usually published in the accounts but ROCE much less frequently as far as I can see.

Dod

[simoan]

FWIW I agree with the others. There's a good reason why Phil Oakley does not cover ROE in his book about Quality Investing and why I don't personally use it - because unlike ROCE is takes into account how the company is financed. It's not really much use unless you are using it for financial companies IMHO when things like leverage may be important and a company does not otherwise deploy much capital, in which case you can use it in place of ROCE.

Anyway, you may find what Phil has to say on ROE interesting: https://www.sharescope.co.uk/stepbystep_8.jsp#ROE

All the best, Si

[TheMotorcycleBoy]

Thanks everyone.

On the whole this is music to our ears....the less valuation parameters, the better!

From what I've been thinking lately, the debt measuring parameters are an area I want to consider a lot more soon. Ultimately, they just might help us spot a firm like a Carillion or Woolies before we invest in them. Well that's the plan anyway.

M&M