ROE is probably the most important computation for a value investor – The problem faced by many is how do you compute ROE?
1. Study profit before and after tax – how does tax affect the company? Is it having a tax holiday? Is it taxed at a lower rate? You can take either profit before tax or profit after tax – but be consistent – if not have a good reason for not being consistent.
2. Adjust for minority interest in profits – CSE has more group companies
3. Quality of earnings – does earnings fluctuate a lot and are declining or stable and growing? Earnings are coming mainly from a declining or shrinking market, Competition in the Company’s industry is fierce (telecom), is the company’s raw material price going up? (gas/fuel), Is the company’s product price increasing?, Does the company have a track record of innovating new and successful products?
4. If the company has large cash balances you must find out what the company plans to do with the cash – this will have a big impact on profits
5. Adjust for discontinued operations – loss making operations are usually discontinued by companies with good management
6. Increase profits by a % - usually less than 10% for companies with good management – its controversial adjustment but a useful one for the value investor
7. Impact of future projects – revise profits up/ down based on your own judgment
8. Adjust for one off transactions – e.g. sale of buildings/investments etc
9. Adjust for hedging or other complex transactions that the company may have entered into
10. Always check related party transactions – and adjust
11. If the company has made big acquisitions always check if financing can be paid off by the increase in earnings – e.g. Softlogic
12. If the company is capital intensive then also check the return to total assets
13. Always check the audit report
14. Don’t compare apples with oranges when you have to decide between two companies with high ROEs
The above factors deal with the numerator.
As for the denominator - the equity – take the average equity available to the company during the period – you may have to further adjust this if the company has had a recent big IPO/ rights issue or has not revalued assets for a number of years.
When comparing the ROE of a company with the P/E ratio - Remember that a high P/E ratio does not always indicate that a company share is too expensive. Sometime companies with exceptional potential have high P/E number.