Danger Zone: Making investment decisions based on return on equity

Investment decisions have always been about assessing the level of risk against the relative return. Over the past decade when interest rates were at record lows, the concept of risk often took a back seat in favour of chasing returns. With inflation soaring and interest rates rising, it is timely to revisit the concept of risk and the pitfalls of making investment decisions based on return on equity alone.

Why volatility is a poor predictor of risk

In investment parlance, the concept of risk is often coined around the volatility of returns. Put simply an investment is seen as riskier if the variance of returns around the mean is high. Over the last 12 months we have seen extreme volatility in both equity and bond markets, but this does not necessarily mean they are inherently riskier than investments in unlisted markets. In fact, the whole concept of risk is inherently flawed as the rapid adjustment in price of bonds and equities is also a function of their liquidity rather than risk alone. Just because an asset rapidly rises or falls in price does not mean that the underlying business is necessarily risky, or the balance sheet is stressed.

It makes no sense that a listed property assets has fallen 30% when the unit price of an unlisted property asset holding a similar type of underlying properties (in terms of type, quality and leverage) has barely moved. Unlisted assets typically have much lower liquidity and therefore the concept of price discovery is slower meaning unit prices take much longer to adjust. This is why we believe volatility alone is a poor predictor of risk.

Return of equity

In similar terms, we equally believe that another common mechanism to predict future shareholder returns, the metric known as return on equity, is similarly flawed. Indeed, a common strategy by private equity players and investment bankers to add shareholder value is to simply increase return on equity by the use of debt without sufficient regard to the associated risks.

How does it work?

The concept of increasing return on equity by the use of debt is best shown by an example:

Example 1

XYZ Corporation Limited has $200 worth of assets and a $50 worth of debt. It has one shareholder. The net assets or equity held by that shareholder is therefore said to be $150. XZY Corporation makes a profit after tax each year of $20.

Return on equity = profit/equity = $20/150 = 13.3%

XYZ decides to buy back shares by increasing debt. This changes its mix of debt and equity such that it now has $50 more debt but $50 less equity. Its overall profitability remains unchanged but the return on equity to shareholders increases appreciably from 13.3% to 20%.

Return on equity = profit/equity = $20/$100 = 20%

By simply changing the financing structure (mix of debt and equity), all other things being equal, shareholder returns can improve. As many executives are measured on total shareholder return, it is not surprising that the bias towards debt is commonplace. The attraction was compounded by the low interest rate environment experience over the last decade – debt was cheap and easily sourced.

The other supposed benefit of more debt

The other key benefit of debt is a reduction in what is known as the weighted average cost of debt. It is the weighted average cost of debt (plus equity) that determines the discount rate that is used for valuing assets under the discounted cashflow methodology. This all sounds reasonable enough except the problem lies in that it is calculated using a model known as the capital asset pricing model. Like most models, it’s not without its shortcomings and so rigid adherence to the outcomes can prove disastrous. Again, it is perhaps best shown by an example:

Example 2

XYZ has $200 of assets, $50 of debt and $150 of equity. Its overall profitability remains
unchanged at $20.
Weighted average cost of capital (WACC): = cost of debt x (% of debt to total assets) + cost of equity x (% of equity to total assets)

Where;

Cost of debt = borrowing interest rate x (1 — tax company tax rate)
Cost of equity = risk free rate + (Beta x market risk premium)

Assume;

Borrowing interest rate = 9%
Risk free rate (10-year government bond rate) = 5%
Market risk premium = 6%
Beta = 1 (stock specific risk where market average equals 1)

Therefore;

Cost of debt = 9% x (1-0.30) = 6.3%
Cost of equity = 5% + 6% = 11 %

Therefore;

Weighted average cost of capital = 6.3% x 25% + 11 % x 75% = 9.825%.

Example 3

Now if XYZ changes its mix of debt to equity such that debt and equity are equal, the weighted average cost of capital becomes lower:

Weighted average cost of capital = 6.3% x 50% 11 % x 50% = 8.65%

Now, the final point that needs to be made is how this discount rate (WACC) then impacts upon a valuation. Without going into too much detail, the value of a shareholder’s interest can be
determined by the present value of the future income streams. Again, this is best shown by an example,

Example 4

Using the assumptions in example 2, the income stream is the net profit of $20 per annum. Let’s assume this is constant over time (perpetual). The value of a perpetuity equates to the income stream divided by the discount rate or:

Value of shareholder interest = Net profit / discount rate = 20 / 0.09825 = $203

Example 5

Using the assumptions in example 3;
Value of shareholder interest = Net profit / discount rate = 20 / 0.0865 = $231

In summary, the lower the weighted average cost of capital, the greater the shareholder value.
More debt and less equity can suddenly unlock tremendous shareholder value.

What can go wrong?

The problems with the capital asset pricing model in reality are not necessarily in the theory, but
in the practical application. The two main problems are as follows:

The cost of equity – CAPM refers to an opportunity cost of equity, in effect the value a shareholder requires to be adequately compensated for the risk undertaken. This equates to the income (the proxy being the risk-free bond rate as this is what the shareholder would otherwise be able to receive from a risk-free investment) plus any capital gains made (the market risk premium). In theory, this means the cost of equity is almost always more expensive that debt. This may be so, but from an ACTUAL cashflow perspective the cost to a company is the cost of the dividend payments made. While dividends can sometimes be marginally more expensive than interest on debt, this is ignoring a key issue – there is no compulsion to make dividend payments. Capital can be preserved should the company have encountered a difficult year. In other words, the cost to the company in such circumstances is effectively nil. They don’t have to pay shareholders anything. While this would affect the share price, the net asset position could be preserved. This is extremely important as with debt, no such flexibility generally exists. Failure to make debt repayments generally provides the borrower with some type of immediate recourse, which can lead to receivership or liquidation. So, while debt generally appears cheaper than equity based on the CAPM equation, in reality it can be much more expensive.

This brings us to the next deficiency of the model. The concept of risk. While risk is introduced into the CAPM model (via the Greek symbol for beta), the concept is very subjective and therefore difficult to value. What we mean by this, is that in reality, companies with very high debt levels are riskier but the equations do not adequately reflect this. In other words, the model’s outcomes typically reward debt over equity without sufficient justification. Just ask the CEO of any company that has collapsed because of being over indebted.

In summary, return on equity forecasts need to be interpreted with caution as they do not adequately take into account any measure of associated risks. While debt can be effective when used in moderation, excess exposure can prove disastrous. In the words of the world’s most famous investor, Warren Buffett, ” to finish first, you must first finish”.