15 May 2011

ROE - An Indicator of Company's Organic Growth

In previous post, I mentioned that ROE is one of the key performance indicator for the company management. In dupont model, it shows that ROE comprised of three key parts - equity multiplier, net profit margin and asset turnover. In this post, I will show you why ROE is also an indicator of growth to the company.

An internal growth factor or we call it organic growth factor,
is derived from the formula ROE * RR(retention ratio). For example, if one company achieved 15% ROE, but it gives out all the earned profits to the investors, it will be left zero amount in its shareholders fund and the shareholder fund remains
unchanged. However, if the company retain that 100% profit, the shareholder fund will increased by 15% without taking into account other factors.

In long run, as we know, the long term share price performance is similar to the shareholder fund. So, if shareholder fund increase, the intrinsic value for this company will increase as well.

Howevet, things to take note:

1. A good ROE always shows that there could be some franchise value to the firm. However, we should always remind ourselves that a proper equity multiplier or appropriate corporate finance structure should be found out to achieve optimal intrinsic value to the company.
2. Some instituitional investors would prefer a favorable dividend policy. The more dividend paid out to investor, the less internal growth we can see in the company.
3. Some companies that achieve long term high ROE can be said in a good industry or achieve monopoly situation. However, the companies may issue out the dividends to the investors if there is no good investment opportunities in short run.

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