Return on Equity: How the number could lie to you

How to make your Return on Equity looks high?
Return on Equity does not tell you a whole story. source: Pinterest

In the Full Year of 2020, Altria Group recorded a 98% Return on Equity – way far exceeding the index with 17.17%. In 2021, the achievement is much crazier, the Marlboro maker has a 399% Return on Equity. And it is not a seasonal wonder, Altria has consistently maintained a high level of ROE for a long time. Is its business really that good? Our short post tries to investigate further.

What is Return on Equity?
Mathematically, it tells you how much earnings are for every shareholder’s equity.

For Altria’s case, the number 98% simply tells you that for every $100 you invested, Altria generates $98 in earnings. The $100 is the equity.

Let’s make a much simpler case to get a better picture.

For instance, you and your friend Nikki found a company name Altria. Both of you invest $100. This $100 is equity.

After a year, Altria remarkably makes $98 in earnings. In this case, you have a 98% Return on Equity. You and Nikki make a decision, that $98 be distributed between you two. You love it, both of you. This policy is unchanged for 5 years, and for that period, Altria gives $98 earnings which means that the ROE is 98%. What a miraculous business.

98% ROE annually for 5 years.

Do you see the problem?

What is a good ROE?
Relying solely on Return on Equity as your investment thesis is meaningless without knowing the business.

The problem for you and Nikki’s case is that the company does not deliver future growth.

The Return on Equity number could be maintained at a high level just by taking all the money earned and giving it back to shareholders. The real Altria does the same, it has a high ROE because the Marlboro maker takes all that it has earned and gives it all to the shareholder. Technically, it takes all retained earnings and uses them as dividends. By sharing the retained earnings with the shareholder, the equity in ROE calculation become much smaller, then, you get a high number of ROE. Simple math.

In detail, in FY 2021, Altria generated $4.6 Billion but give $6.2 Billion in dividends. that means, Altria spends all of its retained earnings on paying a dividend.

Wait, is that bad? No, but it implies that management has no idea how to spur growth or indeed there is no opportunity to expand. We don’t like it.

A Good Manager?
A bigger picture of the business.

The ideal investment for us is a good manager that retained some portion of the earnings (instead of giving all to the shareholder) to expand the company’s business. If he/she could not find it – whatever the reason, we prefer to stay away.

In some cases, the board of directors can’t find the opportunity because of the industry itself, which brings us to the next section.

Company Lifecycle
Return on Equity does not tell the complete story.

A high number of ROE, in some cases, show us the stagnating business. At a glance, a company like Altria – the cigarette maker – has no room for growth. In a world that become more concerned about health and productivity, Altria seems not relevant. The management just pours the money to investors – no need to seek any new opportunities. It is not attractive to us. We like to see CEO with ambition and aggression.

Well, it is something that is almost inevitable. Like everything in this world, life runs in a cycle. There is a time when Altria grows, there is a time when the company becomes old and decelerated.