ROE-Payout ratio-Bookvalue

Hi there, I have the following question:

I Look for companies with high return on equity, little debt and payout ratio of 30-40%. Sometimes I find companies with these numbers, but they don't show an increase of the book value (even after several years). What is going on here? Where does the money go?

Answers

  • That is a tough question to answer in a general sense as the use of free cash can be drastically different from company to company so there is really no easy way to tell you where the money is going if not to increasing book value. One item to note is you have targeted companies with a payout ratio of 30-40% which means you know that 30-40% of the net income is going to paying dividends so one would think that they will have a lower growth in book value than companies that don't pay a dividend.

    Companies with those metrics can also be more established mature companies with little growth prospect so some of that free cash may be buying back shares which won't really change the book value. Reading the 10K filings of the companies in question would give you a better idea of what they are spending their money on.
  • I had to think about it and this is what I came up with based on all your criteria.

    At first I thought maybe it had to do with depreciation and the the asset base is actually growing but the depreciation is nulling the book growth however this would actually increase cash flow and lower earnings so this didn't quite work.


    Then I thought about it a bit more and came up with this.

    If a company has very low debt it is usually going to grow slower as it does not have as much leverage.

    The other thing is that such high return on equity is more of an anomaly. Most companies do not maintain such high levels, they would usually revert towards the mean. It usually represents shorter term earnings spikes. They may be more cyclic companies.

    Same with payout ratio if the short term earnings are high then the payout ratio will be low. However if the earnings go down then your payout ratio may be 80% and and your ROE less than 10%.

    I was watching a value investing video recently in which the guy was talking about really high ROE stock not performing as well because management has little room to improve as their margins are already so good and they may become complacent.

    Where as Peter Lynch was saying that companies with low ROE actually have a lot more room to grow through improved management performance.

    I like ROE as a margin of safety and usually have a minimum of 7% on my screener. I think if you look up the ticker on Morningstar and go to the key stats tab go down and you will see at the ten year ROE is not consistently high at all.

    Matt is right though you have to look at each individual company.

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