No. of Recommendations: 21
Long story short, it's hard to get a meaningful ROE figure. The two approaches to mitigate that seem to be
* live with the fact that a naive ROE calculation will give you the wrong idea sometimes, and just buy a whole lot of high ROE stocks to lose it in the averages, or
* spend some time really looking at a company to see what its return on "meaningful" assets is. Either by hand, or with more and more elaborate screening criteria.
The first thing you'd want to check are that it isn't a high ROE because they've simply geared up too far. For example, imagine a stock with moderate equity and nice profitability, a medium ROE. They borrow a gazillion dollars and pay out a big special dividend, the shareholders' equity drops near zero, and the ROE now seems super high even though it's the same underlying business activity. Years ago, this was called a "recap". This is of course bad: they firm is now highly leveraged and much more at risk of failure, and at the very least earnings are likely to drop due to interest costs. Maybe that's what happened with the firm you looked at? The same thing can come from a huge one-time write-off. Also, fresh share issuance increases equity without (immediately) changing returns, so ROE falls. Huge buybacks depress book per share, flattering ROE if there is enough of it done. Frankly, lots of things can throw it off.
The biggest risk is overgeared firms looking "too good" based on ROE. Checking leverage levels as a simple extra step is wise, if you're placing bigger wagers per company. Usually folks look at debt to equity ratios, but not me. Personally I don't find it easy to pay off debts with assets...ever try to sell half a factory machine to make a loan payment?...so I like to look at the ratio of long term debt to normalized earnings. A firm with debt less than five typical years of earnings is not overly geared. That can go up to 10 years for the occasional firm that has extraordinarily steady and long-lived streams of earnings. Hershey is sometimes used as an example here. This can go to extremes: a few firms have such high reliability of earnings streams that they pay out all their equity, and more, and end up with negative book value while earnings keep on chugging. Naively dividing earnings by equity you get a negative ROE, but in reality this is in effect an infinite ROE: they don't need any net assets at all to earn money, and on average they are good investments. Moody's, Coke, etc. But that's rare. In fact, a tiny number of firms with super high P/B also makes a good screen for analogous reasons, but I digress.*
Another check which makes a lot of sense, but which oddly I don't usually do, is to look at ROA instead of (or addition to) ROE. As much as possible, you want to look at what return they're getting on the assets they are actually using to generate their earnings. A really big disused pile of cash would not be included.
In short, a high ROE emphatically does not mean you are looking at a great business, because of flaws and gotchas like those above. However, essentially all great businesses have high (or infinite) ROE, especially over long periods. So, despite the outliers, a large slate of firms with high ROE will have a higher-than-average chance of having above-average quality compared to a randomly selected set.
To your specific question, do I look at recent or multi-year average ROE, I have historically tested things only with recent ROE because that's what I had available. But when I'm doing global equity screening, I look at five year average ROE because the screener I use for that has that field! Really one should check both: high average so you know the recent figure wasn't just anomalously good because of a one-time gain, and high recent so you are skipping firms that just had a permanent turn for the worse, or highly variable year-to-year returns.
Sorry for rambling, I think about ROE way too much. As far as I know, if you wanted to do quant investing and had only one field you could use, that's what I'd pick. Despite the flaws.
From within the Value Line 1700 set, equally weighted portfolios:
1997-2025, top 25% by ROE, 13.07%
1997-2025, bottom 25% by ROE, 9.53%
1997-2025, S&P 500, 9.94%
Jim
* Here's a surprising one for a "deep value" investor
2000-2025, S&P 500, 8%/year
2000-2025, top 8 from VL set by price-to-book-value (i.e., seemingly most overpriced), 16%/year
The reason this works: to a very crude first approximation, people pay similar P/E ratios for companies. If the P/E ratio is comparable to the average but the P/B is very high, the firm must have a high ROE. Firms with consistently high ROE have something that is preventing others from raising money to undercut them, some sort of moat or monopoly: if it only takes a few assets to be in that business, everybody would want to do so.
