The return on equity (ROE) is widely used by financial analysts worldwide to gauge a company’s performance. This profitability ratio is calculated by dividing profits (net income) by shareholders’ funds. Essentially, this ratio measures the amount of profit a company generates with the money shareholders have invested. It shows whether management is growing the company’s value at an acceptable rate of return.
The ROE can be calculated using either pre-tax profits or profits after tax. The figure of after-tax profits is a better gauge of the actual return for shareholders. A number of companies operating in certain sectors enjoy beneficial tax rates for various reasons and therefore such companies are in a better position to register improved shareholder returns than those companies that incur higher tax levels. The tax aspect must also be taken into consideration by investors when searching for attractive investments.
Meanwhile, rather than using the level of shareholders’ funds or capital employed at the beginning or the end of the accounting period, the average level of shareholders’ funds is normally used. This is calculated by adding the shareholders’ equity at the beginning of a period to the shareholders’ equity at the end of the financial year and dividing the result by two.
It is not surprising that the ROE is among the main indicators used by the legendary investor Warren Buffett when seeking new opportunities for his investment vehicle Berkshire Hathaway. Value investors like Warren Buffett normally ignore the supply and demand dynamics of the stock market that impact daily price movements. Instead, they search for undervalued companies with strong fundamentals using various measures including the ROE since they believe that over time the market will correctly attribute a fair value to such companies. In fact, one of Warren Buffett’s famous quotes is “in the short term the market is a popularity contest; in the long term it is a weighing machine”, indicating that share prices generally follow company fundamentals.
As explained in my two most recent articles, company earnings will remain among the key drivers of equity market performance going forward following the sharp upturn in 2013. Hence, the ROE should be a widely used indicator to analyse the level of returns from various companies across different industries. However, such a ratio should only be compared among companies within the same industry.
It would be incorrect to compare the ROE of companies operating in different sectors due to the varying characteristics from one industry to another.
A company’s track record over a five- or 10-year period would be important to analyse while the sustainability of such returns in the future is also a key factor for consideration before proceeding with an investment. The table shows those companies listed on the Malta Stock Exchange which registered double-digit ROEs in their last financial year. Since most companies have a December year-end, the returns are therefore based on the 2012 annual financial statements.
Naturally, this data could be considered as being somewhat outdated and it would be interesting to analyse the changes in ROEs between 2012 and 2013.
Many readers would probably be surprised that Grand Harbour Marina ranks as the company with the highest profitability ratio.
The ROE for 2012 was an impressive 37.6 per cent. However, it is worth analysing the reasons for this ROE and whether this is sustainable also in future years. In fact, GHM’s high profitability ratio in 2012 was due to the success in the sale of a superyacht berth for €3.1 million during that year. Unfortunately, the company did not report any sales of such berths in 2013 and therefore this ratio is very likely to decline significantly for 2013.
The three companies in the IT sector all feature among the companies with double-digit returns.
Crimsonwing registered an ROE of 24.7 per cent in their last financial year to March 31, 2013 as the company returned to a profitable situation and registered after-tax profits of €0.77 million. Crimsonwing should again feature among the highest ranked companies also this year since the interim financial statements to September 30, 2013 showed a strong growth in profits after tax to €0.6 million and the directors confirmed a positive outlook until the end of the current financial year to March 31, 2014. Crimsonwing’s full-year results to March 31, 2014 should be published by July.
The 2012 ROE for RS2 Software of 13.8 per cent should also be increasing during 2013 given the expectations of higher profitability growth for the past financial year. In 2012, RS2 had generated after-tax profits of €2.48 million and these surged to €3.7 million in the first half of 2013.
The improved profitability in the first six months was mainly due to the recognition of €5.5 million in income from the BankWorks licence agreement with Barclays Bank. The licence agreement was for £8.5 million apart from other service fees to be generated from the implementation of the system.
The second half of 2013 should therefore have been boosted by a recognition of a further amount of the licence agreement together with service fees being generated on this project. The benefits of this important agreement are also likely to spill over into 2014 and possibly beyond.
Similarly, the ROE of 6pm Holdings for 2012 of 10.2 per cent is also anticipated to edge higher given the 35 per cent increase in net profits to £0.25 million at the half-way stage as well as the improved outlook envisaged by the directors in their recent statements to the market.
Malta International Airport ranks as the company with the third best ROE at 20.5 per cent during 2012.
It is also worth highlighting the consistent increase in shareholder returns by the airport operator over the five-year period between 2008 and 2012 as profitability grew reflecting the record passenger movements in 2008, 2010, 2011 and 2012. The ROE of MIA climbed from 16.6 per cent in 2008 to 20.5 per cent in 2012.
Company earnings will remain among the key drivers of equity market performance going forward
Similar to the IT companies, the profitability ratio of the airport operator is also likely to improve further during 2013 as a result of the circa 10 per cent growth in passenger movements to a new record which should have led to a consequent improvement in profitability. This will be revealed once the 2013 annual financial statements are issued in March.
In the banking sector, the ROE of HSBC Bank Malta is superior to that of Bank of Valletta. An analysis of the ROE’s achieved by both HSBC and BOV in their most recent financial years compared to those in earlier years shows the declining trend across the banking sector which is reflective of the challenges faced by retail banks as interest rates dropped to historically low levels.
Moreover, the need to maintain higher levels of capital due to more stringent regulatory requirements will continue to hinder growth in shareholder returns going forward.
Although HSBC’s post-tax ROE of 16.1 per cent is still very attractive, it is worth highlighting that the bank’s ROE ranged between 20.8 per cent in 2006 and a high of 26.7 per cent in 2008. This dropped to an average of 16 per cent in each of the subsequent four years.
The trend in BOV’s ROE has been more erratic given the increased volatility of its financial performance in the past six years reflecting the impact of bond movements on the bottom line.
The declining returns in the banking sector are also evident from an analysis of the financial statements of Lombard Bank Malta. The two larger banks historically always registered higher ROEs when compared to Lombard Bank and this continued in recent years with the post-tax ROE of the Lombard Group dropping from a recent high of 15.5 per cent in 2008 to 7.5 per cent in 2012.
The financial statements of Lombard include those of Maltapost and the ROE of the postal operator has also been on a downward trend in recent years dropping to 8.1 per cent in 2012. MaltaPost’s decline is mainly as a result of a weakening in profits coupled with a consistent increase in equity over the years as most shareholders have opted to take shares in lieu of cash dividends.
Also in the financial sector, the ROE of Middlesea Insurance for 2012 of 15.1 per cent is expected to improve given the expectations of a stronger financial performance reflecting the positive movements across both local and international financial markets in 2013.
However, the sustainability of such a return in the case of Middlesea is almost entirely dependent on further positive movements in the group’s investments as growth in income from core insurance operations, especially general insurance, is challenging.
The companies that suffered a loss in their 2012 financial year naturally did not register a positive ROE. These companies include International Hotel Investments, Midi, Medserv, Island Hotels Group Holdings and GlobalCapital.
The reasons for their weak financial performances differ in all cases. While all companies are again expected to have registered losses in 2013, it is worth highlighting that Medserv published its financial estimates in the documentation issued in connection with their recent bond issue. Medserv indicated that the group should return to profits in 2013 and 2014. The company estimated profit after tax of €1.6 million for the year ended December 31, 2013. This would translate into a return on equity of circa 19.5 per cent. Following Medserv’s erratic performances in recent years, investors would need to understand whether the company could maintain double-digit returns also in future years.
Although no single metric or financial indicator can provide a perfect tool for examining company fundamentals, an analysis of the trend in ROE over say a five-year period and making a comparison to other companies within the same sector would be very useful to understand whether a company has a competitive advantage and the ability of delivering superior shareholder value over time.
While the historical returns and trends are important when undertaking an analysis ahead of an investment decision, the expected future returns are naturally of greater importance for equity investors.
Management of public companies should therefore do their utmost to provide detailed but conservative information on the expected outlook going forward including targeted profitability returns.
| ROE | Year end | |
| 1. Grand Harbour Marina plc | 37.6% | December 2012 |
| 2. Crimsonwing plc | 24.7% | March 2013 |
| 3. Malta International Airport plc | 20.5% | December 2012 |
| 4. GO plc | 18.7% | December 2012 |
| 5. HSBC Bank Malta plc | 16.1% | December 2012 |
| 6. Middlesea Insurance plc | 15.1% | December 2012 |
| 7. Bank of Valletta plc | 14.4% | September 2013 |
| 8. RS2 Software plc | 13.8% | December 2012 |
| 9. 6pm Holdings plc | 10.2% | December 2012 |
Rizzo, Farrugia & Co. (Stockbrokers) Ltd (RFC) is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the issuer/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. RFC, its directors, the author of this report, other employees or RFC, on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither RFC nor any of its directors or employees accept any liability for any loss or damage arising from the use of all or any part thereof, and no representation or warranty is provided in respect of the reliability of the information contained in this report.
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Edward Rizzo is a director at Rizzo, Farrugia & Co. (Stockbrokers) Ltd.