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  1. #1

    How do you choose to calculate ROE

    I'm wondering if some of the posters here would be willing to weigh in on how they calculate ROE. Thegipper's comments regarding MTY food group in the What did you buy thread have me wondering about this again. I keep seeing different ROE's for the company depending on the source. In the past I just used net income divided by shareholder equity. When I started researching Visa and MasterCard a few years ago, I realized I had to adjust for treasury stock on the balance sheet to get an apples to apples comparison (when Visa buys back shares, they just retire them. MasterCard carries them on their balance sheet as treasury stock which depresses shareholder equity. The net result skews the numbers significantly). In the case of MTY, I think the discrepancy results from some sources using free cash flow instead of net income for the numerator.

    ROE and ROC are numbers I always consider when contemplating a potential investment, but I'm not sure we're all on the same page here. This is a bit of a concern for me, because I always considered ROE as a very straight forward calculation. I'm pretty sure Jason Donville uses the Dupont analysis, which I haven't really got my head around yet. How do the rest of you calculate it?

  2. #2
    It is an interesting question. When Visa cancels their shares does it increase goodwill? Reason I ask is I thought that is the effect I saw when I was looking at a different US company that was doing share buybacks, and I really am not that familiar with the accounting rules. A few years ago there were complaints about the amount of retained earnings on company balance sheets here in Canada. I do look at ROE also as it is an indication of profitability, usually I just use the numbers my broker supplies. I look at the other measurements like PE, ROC, and book value supplied by the broker also, the information is available so I try to use it when forming my thoughts of the company. Even when I look at the financial statements there isn't one particular thing I rely on, it is more like there are a number of things being told, I think I have a better understanding of the balance sheet than I do of the cash flow or income statements.

    The 'training' I use to read a balance sheet is from a 1971 Merril Lynch document my dad obtained when he started investing. It also talks about the income statement, which I should review again as the balance sheet section stuck better. The document is very oriented to industrial stocks and from what I have seen, other sectors of the stock market are measured differently than as presented in the document.

  3. #3
    The standard way of calculating ROE is by dividing net income (from the company's income statement) by average shareholder equity (average of shareholder equity at the start of the period and shareholder equity at the end of the period) (also from the company's balance sheet).

    While the definition is stated simply, I find that its implementation is anything but easy. Depending on the company and the analyst, a host of adjustments can be made. For me, the most important are

    (a) inclusion, or not, of one-time events, especially if one-time events occur year after year

    (b) timing of recognition of revenues

    (c) depreciation policies

    (d) treatment of intellectual property / goodwill

    (e) consolidation of subsidiaries / treatment of investments in affiliates / joint ventures

    (f) outstanding liabilities for pensions and post-retirement benefits

    Increasingly, I find myself sceptical of ROE as reported by companies. On the other hand, I don't have the time and resources to make the adjustments I think necessary. So I don't use ROE in investment decisions.

  4. #4
    I think ROE is as important an indicator (despite its flaws as already pointed out by George) as other key indicators, especially when viewed over the context of multiple years. Anything with an E in the metric is going to have its warts, just as anything with CF in the metric is going to have its warts. While CF is harder to manipulate than E, it says very little about the company's ability to improve, maintain, or destroy shareholder equity over a long term basis. After all, a shareholder's primary interest should be about return on investment, no?

    FWIW, I accept the conventional definition of ROE as described by George partly because I am also too lazy to dig into the details, and partly because I'd have to dissect multiple years of financials to assess the trend and potential shenanigans.

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