Jurgis:
For some reason I get the feeling that I am being treated the mudge thread way...
I'm sorry, I don't know what that is. I just got the impression that you were already digging into this stuff and just wanted to know where to look.
Yes, you are right that high D can make ROE look good.
Here is a very simple way to see a potential problem with the "E." You have already acknowledged the possible distortions of "R." Yet equity has a component "retained earnings" - which is basically the sum of those same earnings you doubt. You could have a company with negative FCF showing earnings, funding itself through share issuance (maybe a little debt) which can show a fairly constant ROE. At some point, that can catch up with the company.
I will repeat the request to elaborate.
The method basically suggests that returns will scale with ROE, which makes intuitive sense. Given a company with high ROE then, so long as you aren't starting out with a very high P/E, you should make a very good return. What you will find is that those returns have not, in practice, scaled with the ROE. Look a little closer and you will see that the high ROE has often been maintained by minimizing book value or minimizing growth in book value. The actual growth in profits has been below what the ROE suggests it could be. e.g., KO, SGP WD-40.
You stated, I believe, that you put a cap on the P/E you will input. I submit that a high ROE, because it is compounded, offers a source of error that is at least as great.
- Pirah |
