Understanding reinvested return on equity

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Return on equity is widely regarded as a key measure that investors should use to judge the quality of a company. But few investors go one stage further and combine this measure with other profit and loss numbers to arrive at a more precise value.

One important way this can be done is by looking at a combination of return on equity on the one hand and the company's retention rate on the other. The retention rate is the proportion of after-tax profits which is not paid out in dividends.

These two values combine to produce the concept of reinvested return on equity. This is a number that can be manipulated in a simple mathematical way, to assign a future value to a company and to gauge whether or not its shares are cheap or expensive.

Return on equity is a measure of how efficiently management is deploying the cash invested by shareholders.

The best and most accurate way of looking at this is to express after-tax profits as a percentage of average shareholders' equity. The return generated by the company can in this way be compared with other forms of investment returns such as those on bank deposit accounts and gilt yields. After all, if a company's return on equity is so low that it is less than the yield on a gilt, what is the point of investing in it?

The retention rate is important because if a company has a high return on equity, the best thing for the shareholder may be for as much as possible of that high return to be retained and reinvested in the company to generate further returns. In this case, whatever dividends are paid to shareholders 'leak out' of the company and cannot be reinvested.

A company that has an after-tax return on equity of 30%, but which pays out half its earnings in the form of dividends is - in effect - on the same basis as an inferior quality company with a 15% ROE that pays out nothing.

As a shareholder receiving the dividend in this case, to be better off on balance you would have to try and replicate that 15% return the company has foregone by investing the dividend yourself elsewhere. That may be difficult. We all tend to overestimate our stock-picking ability and a proven growth stock generating high returns can be one of the best long-term homes for your money.

By projecting the impact of reinvested return on equity, it's possible to value a company for any given level of ROE, dividend payout, and risk-free rate of return. It is a simple way of getting down to the nub of long-term share valuation.

Once after-tax return on equity is worked out and adjusted to reflect the proportion of profits retained, simply multiplying this into current after-tax profits and compounding for five years can produce expected after tax profits in five years' time.

Put this latter number on a market multiple and add in the value of cumulative dividends in the intervening period and we get to a 'year five' value for the company, which can then either be discounted back to arrive at a present value, or be compared with the current market capitalisation and an implied compound future share price growth rate worked out.

Companies can be compared quite easily along these lines irrespective of their differing returns on equity and differing dividend payout policies.

Peter says

There are advantages to the reinvested return on equity method of valuation. It's not perfect, and it's not the only valuation tool there is, but it is a good addition to the box of tools an investor can use.

The calculation can be incorporated in a spreadsheet without much effort. It also gives due weight to the importance of return on equity in generating value for shareholders, which many other methods of valuing shares don't. It rewards those companies that retain a high proportion of their profits for reinvestment in the business. And it allows market yields and earnings multiples to be incorporated into the valuation, rather than a more random variable.

There are, however, some drawbacks to it. It works well only with those companies that have relatively straightforward balance sheets and a steadily growing business. Asset-based investments, or income-orientated ones, do not fit well with this approach.

Since these are also legitimate investment choices, other methods of valuation have to be used for them.