What Is Return on Equity (ROE)?

[from investopedia] Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets.

ROE is considered a gauge of a corporation’s profitability and how efficient it is in generating profits. The higher the ROE, the more efficient a company’s management is at generating income and growth from its equity financing.

Return on Equity and mean reversion considerations

Business owners tend to demand at least 15% return on equity for accepting equity risks. If the return on equity, ROE, is lower than 10% there is little reason to stay in business long term. Given the capital destruction of winding up a company, low return businesses are typically sold or transformed in some way to increase the level of return. If a company with a history of 15%-type returns experiences one or a few low return years, but has a credible plan for improvement, it can prove to be a good investment opportunity.

Is a turnaround actually likely?

Some turnarounds are, however, more or less likely than others, so it’s important to consider whether management has the right experience, and whether the competition and the business have undergone any changes that would make a turnaround less likely. For example, it’s hard to compete against giants like Microsoft, Nvidia, Netflix, Amazon, Apple, Meta and Alphabet. Hence, if the reason for falling profitability is the emergence of industry giants, the likelihood of a turnaround is much lower.

Sometimes the devil is in the details

In this case, the devil is really in the details, i.e., in the particular industry and companies involved. As a general point, in more stable and cyclical industries with a history of mean-reverting growth rates and profitability, it’s often reasonable to assume that periods of below-average returns are followed by periods of higher returns, and vice versa.

Reliable forecasts and moats 

Remember what we are trying to do here: making reliable forecasts.

The way we do that is by looking at the actual historical performance across various factors to identify patterns that can be extrapolated into the future.

It’s not as simple as assuming the same growth rate or ROE as the previous year. Instead, what we are looking for are likely tendencies for change from the current situation. These tendencies can help bring the company’s performance closer to a natural average. This average is an amalgamation of the company’s past performance metrics (such as growth rate patterns, profit margins, and ROE etc.), the growth rates and profit margins of its industry and peers, and the overall economy’s numbers.

There is a constant competition for resources and clients, and companies are always trying to get the upper hand through efficient and low cost production and distribution, proprietary technology, attractive design and so on. The competitive landscape often leads to a tendency of mean reversion. High growth rate, profitability and returns attract new entrants that over time lowers the profitability. Consequently, one should not assume indefinite supernormal growth and profitability, unless there are compelling reasons to do so. Such reasons may include strong moats, durable competitive advantages in terms of scale, regulation, innovation and barriers to entry.

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