Wrong investment decision from incorrect reading of return ratios:

Return ratios are considered as one of the most important metrics in evaluating investment prospects. In our quest for finding ideal investment opportunities, everyone will enquire what is the return ratios of the prospect? Many globally renowned investment gurus have maintained, they look at their investment and ask if they can deliver higher return ratios for a long period of time. They connect this higher return capabilities as the moat of the business.

There should be no doubt in any one mind that the return ratios should always looked into before making investment decisions. However, there are some areas where return ratios are wrongly used to make the investment case and I would try to put my argument over cases where return ratios are blindly appreciated. Since, I am based out of India and most of the understanding  has been from Indian capital markets, I would restrict my argument for Indian markets.

Let’s understand in simple terms what return ratios mean for investment decision. Investopedia says "Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested." In simple terms suppose Rs 100 was invested as equity in a business (say a restaurant), may be some time ago, and today that restaurant is generating Rs 20 as profit after tax, one can simply say the business is making 20% RoE. Now investor would compare this restaurant with other restaurant/investment opportunities and see which business or owner is able to make maximum of the invested 100 buck.

This concept work well for western countries where the inflation is very low. US, UK and Japan central government are struggling to increase their inflation rate to mere 2%. while India has always witnessed high inflation, RBI will never dream of bringing down inflation to 2%. 

Indian companies follow conservative accounting policy which means showing assets in balance sheet at market value or original value whichever is lower, so assets will be shown at historical value. Plus, there will be depreciation for wear and tear, which brings down the value of assets further in balance sheet, even though the replacement value of the same assets in current condition might be 2x or 3x, it will be recorded in balance sheet as book value minus depreciation. This is one side of story where assets in countries with high inflation and conservative accounting policy will always recorded lower than fair as denominator for RoE.

Let’s look at the profit side, the numerator of the RoE ratio. Profit is driven by what prices are charged at the restaurant. A restaurant will not charge lower price just because that property was acquired few years ago and prices where low back then. It will not charge lower price even if the acquisition has done recently and owner got a cracker of a deal and bought the property at a bargain. Revenue is always marked to market, based on current economic conditions.

Now, Let’s compare two business, one/ which has assets recorded at lower than fair value and there is another restaurant which is newly opened and assets is current market price. Since India always had high inflation rate, replacement value will normally be much higher than recorded value in the books. Here, just comparing return ratios as reported by the company, doesn’t lead to proper investment decision. If company with lower reported assets is considered better investment decision, then decision is not relying on business ability to generate higher return ratios. Rationale for selecting the business is that promoter will keep on adding new restaurant at bargain value. If that is the reason this Promoter should be compared with DLFs of the world and not the CCDs. 

There are certain instances when it becomes completely wrong to consider return ratios for investment decision, mostly in capital intensive manufacturing units where assets have long history. Think that you are comparing SAIL return ratios based on assets built over life of the company and comparing it with Tata Steel Kalingnagar plant which is built recently.

Comparing return ratios for a bank is fine, as significant portion of assets in balance sheet will be loan and advances or investment which are regularly mark to market. Hence, no distortion there. Even for service companies, they generally don't own hard assets. Infosys might not own building and hard infrastructure to do business, they will be taking it on lease instead. So the rentals booked in P&L would be again as in banks, mark to market.

The level of distortion doesn't end there. I was comparing two companies return ratios and face difficulty is showcasing my investment case due to skewed return ratios. Distortion in my case was further aggravated as one company has done regular acquisition and when you do acquisition assets value will be bought to normal current price or you might have to pay goodwill if the assets is added to the balance sheet at historical value.

To address issue to distorted return ratios, when assets is recorded at low value. One should start looking at inverted PE ratios instead of only return ratios. It gives picture to investor what he is currently paying for the business and whether business is doing well enough to return the money is shortest possible time. However return ratios should continue to be critical factor for banks and financial sector.