Many investors track ROE but diversifying metrics used can aid in balanced investment decisions

WITH the long hoped-for US Federal Reserve rate cut likely to materialise after next week’s meeting, companies are looking forward to some relief in terms of lower financing costs.

Among other positive benefits could be a boost to equity markets. Return on equity (ROE) is an important metric, showing how effectively a company is using its capital to generate returns. It increases when net profit – the numerator – rises, assuming the level of equity – the denominator – remains constant.

Companies with higher ROEs are generally rewarded with higher valuations, says the head of research at Phillip Securities Research, Paul Chew. Lower interest rates “can place less pressure to keep up the ROEs since (returns from) alternative investments such as fixed deposits or bonds will be lower”, he says.

After all, before the rate hikes that started in 2022, ROEs were in general higher, especially for those companies who used debt to grow.

Useful for bank stocks

Some of Singapore’s largest companies have disclosed their ROE targets. DBS Group is confident of achieving an ROE of 15 to 17 per cent in the medium term or over the next three to five years, chief executive officer Piyush Gupta said earlier this year. 

UOB, for its part, is targeting an ROE of 13 to 14 per cent, with the chance for further upside if the bank’s fees from its wealth business or trading activities do well, UOB group chief executive and deputy chairman Wee Ee Cheong said in April.

Chew points out that ROE can be a useful metric when looking at banks. Investors value banks on their price-to-book ratio and this is dependent on sustainable ROE. Bank earnings are cyclical due to provisions which may be lumpy while price-earnings ratios (PE ratios) may be volatile.

ROE is one measure of a company’s profitability and efficiency. Managing director at Teneo’s strategy and communications business, Tok Chong Yap, says: “A higher ROE value shows that the business is deploying and utilising equity effectively to drive higher shareholder returns.” 

Management can use ROE to show how effective they are at reinvesting the retained earnings into the best investments and opportunities for growth. Many annual and long-term remuneration packages include ROE in their long-term performance targets, Tok adds.

Large companies tend to disclose ROEs for the benefit of investors. ST Engineering’s ROE for 2023 was 23.8 per cent, but it does not reveal its targets for the metric. According to a recent JPMorgan report, ST Engineering’s ROE for 2024 is estimated to be 27.2 per cent, the highest among eight Asian aerospace companies.

For smaller companies, ROE may be less useful for investors. Phillip’s Chew says that “most investors buy smaller companies for growth”, which means that PE ratios are the preferred benchmark. PE ratios and earnings growth are the priority for small caps, he notes.

Beyond ROE numbers 

In addition, ROEs should be compared within a peer group to enable like-for-like comparison and to take into account factors specific to an industry. Teneo’s Tok points out that ROEs in capital-intensive sectors such as manufacturing, utilities or real estate will be lower relative to asset-light businesses such as technology, asset management or service industries.

Other factors that affect ROE will be one-off gains or losses which do not reflect the ongoing operational performance or share buybacks that reduce the overall equity pool, he adds. Investors therefore need to look more closely beyond the ROE figures.

And depending on their profile, investors will look at other metrics too. 

Fixed-income investors will be more concerned with how well the company is generating free cash flow and servicing the coupons. Growth-seeking equity investors may be looking at the price/earnings-to-growth (PEG) ratio.

Return on invested capital (ROIC) is also a good performance indicator as it determines how well a company uses all its available capital to make money. This is a useful metric when the cost of capital is high, analysts say.

Earnings before interest and taxes can also be another measure.

For wealth management firm Paragon Capital Management, ROE is a useful metric, but it often relies on another measure – that of net profit margin (NPM) – to evaluate a business.

CEO Paul Lee says that its aim is to invest in large businesses that are well-run and sustainably profitable; hence NPM, which uses total revenue as the denominator, is another helpful indicator.

Even as the investing environment is set to improve with lower interest rates, investors should continue to keep a close eye on the numbers. Diversifying the metrics used will likely lead to more informed and balanced investment decisions.