Investing in stocks means you put your money into a real business. One that has to take that money, and turn it into more by making profits through sales to clients.

It is as simple as that.

And, there’s a single financial figure that can tell you just how effective businesses are at turning YOUR money into MORE money!

Return on equity – and how it affects your investment decisions

Return on equity is a financial measure that tells you how well a business turns money invested in it by shareholders into profits, and value for these shareholders.

A more formal definition is that: “Return on equity (ROE) is a measure of how efficiently a company uses its assets to produce earnings”, and understanding this value can help you evaluate stocks.

How to calculate ROE

Return on equity is calculated by dividing the net income of a firm by its shareholder’s equity.

Shareholders equity is basically total assets minus total liabilities. It is how much shareholders will get if the firm was sold today. We could also call this the book value or net asset value of the company.

So, if a business has R10,000,000 in net income, and the value of its total assets is R50,000,000 we calculate its ROE as 10,000,000 / 50,000,000 * 100 = 20%.

A healthy ROE is 10-15%. But as with all these financial metrics, you should also compare them between companies in the same industry to get a better idea of what they actually show…

Similarly – ROE shouldn’t be viewed in isolation. You would typically combine it with other financial metrics to get a better picture of a company, within its industry.

South African banking stocks compared by ROE

In recent weeks there’s been a lot of debate in financial media about banking and whether they show opportunity or not.

So, let’s look at the SA banking sector as an example, and how these stocks rank by ROE, and what it can tell us about these companies…

If you look at this table – it effectively shows what the news article was saying you can spend on a car – based on your income.

The income’s quoted here are GROSS monthly income. In other words, before tax.

That means after tax the situation looks even worse…

Looking at the above table you can see that Capitec has the highest ROE of the banking sector.

In short – it reflects the company’s fast growth. There are many reasons for this. But in short, the company has lower costs than other banks, meaning it makes more profit for every rand it invests. Newer IT infrastructure, and a more frugal corporate culture are probably the biggest reasons behind this.

First Rand and Standard Bank around the 19% mark still have above average ROEs. These companies are the two largest SA banks by turnover. And for the most part they are fairly innovative, and good allocators of shareholder funds.

Absa and Nedbank have the lowest ROEs. Nedbank’s ROE is only 13.22%. That means for every rand invested in Nedbank the company will generate almost half the returns that Capitec would!

Companies can improve their ROE by:

1. Increasing sales
2. Increasing profits
3. Increasing profit margins
4. Making more effective use of debt
5. Improving asset utilisation/efficiency

Again – Capitec is a much younger business. It has only started to venture into business banking. It doesn’t even have a full home loan offering yet… Simply put – the bank could introduce more services like these and increase sales. It could increase how many clients are serviced by a branch to improve its asset utilisation. Even a slight increase in banking fees would improve profit margins…

A bank with a mature business, like Nedbank, would find it a lot more difficult to improve the same metrics as Capitec to grow its business significantly from here on.

It would however be worth it to consider the absolute profit levels, as well as the dividends that these companies pay investors before making a call on whether a stock is a buy or not. More on that in another letter.

PS. To find out where I’m investing my money, go here.

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