Thinking incrementally

We have broken down one of the core metrics used in financial analysis, return on equity (ROE) which measures the profit generated on the capital inserted into a business by its shareholders.

Equity takes on two forms, capital directly injected into a business through its creation or subsequent capital raisings, and the earnings attributable to shareholders that is retained within the business to be used in the future.

ROE (return on equity)

Although the ROE metric is useful as it may not always tell the full story. For example, a business like IRESS Limited, which is a provider of financial services software. IRESS is dominant in its market, because of that it lacks growth opportunities. Despite reporting a solid ROE, the return on incremental equity (ROIE) shows the difficulty management faces finding places to invest capital to generate further returns for shareholders.

We calculate the ROIE by taking the change in shareholders equity from one financial year to the next. And then compare that against the change in net profit from one financial year to the next:

The chart above displays the IRESS’s ROE (blue line) that has stayed steady over the last five years. At around 15%, a very respectable number that would pass most investing checklists. However, the ROIE (orange line) tells a deeper story, showing that three of the last four years of the business, has not only earned a ROIE below its ROE of 15%, but below 7%. Which would be lower than the cost of equity for many investors.

ROIE (return on incremental equity)

The reason why ROIE is important is the ongoing return a business can generate on its capital is a very good indicator of its competitive moat. A business who can continue to generate high returns over a long period of time generally has some sort of advantage that prevents competitors from competing away those returns. A high ROIE may show a company who is growing their moat, while a low one may show one who is losing theirs.

ROE v ROIE

Let’s look at the ROE v ROIE for long term Emerging Companies portfolio holding Altium, who is also a software company. Altium target market is still structurally growing and offers areas to re-invest incremental capital see below:

The opposite of IRESS, Altium have been able to take their retained profits and generate extremely high incremental rates of return. As investors, this allows our capital to compound and if a business can do that over an extended period of time you will often see share price charts like this, comparing Altium (blue) and IRESS (green):

Of course, hindsight investing is always easy, so how can we use incremental ratio analysis when looking forward? Some scenarios I look for in the Oracle Emerging Companies portfolio include:

• If a capital light business has been heavily investing in their moat with large operating losses, a growing ROIE may be the first sign that scale is emerging.

• If a capital heavy business has had a period of extremely poor ROIE due to high capital investment, a growing ROIE again may be the first sign that capital expenses are slowing down and a period of strong free cash flow generation may begin.

Keep in mind if the business inflection point is genuine, the ROIE will show it first.

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Important information

Advisory Group makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.