Mike,ROE question refers.I attach almost no importance to ROE...

Mike,

ROE question refers.

I attach almost no importance to ROE per se (I do it indirectly, but not directly on the cold, hard ROE metric, as defined by NPAT/Shareholders' Equity).

And the reasons for that is that both the numerator (NPAT), and especially the denominator (Shareholders' Equity), are non-cash flow based accounting constructs, and are often quie meaningless.

I cannot stress enough that the notion called "NET PROFIT AFTER TAX" (from which EPS is derived) is not an absolute and precise value; instead, it is an APPROXIMATION (often a good approximation, but an approximation nonetheless) of corporate profitability. The P&L is a function of accounting standards and practices which are not univerally perfect (which is why they are constantly changing). There is a significant amount of intepretation and subjective judgment that gets brought into play when the P&L is being compiled...practices and treatments vary from company to company, from board to board, and from audit committee to audit committee, in respect of items like revenue recognition, depreciation policies, the raising and utilisation of the various sorts of provisioning, treatment of goodwill and other intangibles, cost capitalisation, interest capitalisation, tax determination etc. etc.

When people say "Company X made a profit of $100m" What they really should be saying is "Company X made a profit of $100m plus-or-minus $20m."

And if NPAT is an approximation for any given single financial period, then Shareholders' Equity is an approximation that has inconsistencies or irregularities that compound over many financial periods, rendering it, at best, a crude estimate of Total Assets less Total Liabilities. (A classic example is SFH - where coincidentally - a fellow poster has made the mistake of taking Shareholder's Equity, as reported by the company, at fact value in calculating ROE, when that value, in fact, bears no relation to practical reality.)

This is why companies trade at different values (mostly premia, and often very significant premia) to their Net Asset Value, is. Shareholder Equity. (As an asides, in strict valuation theory terms, if a company's ROE is equal to its cost of equity, then the stock, in an efficent market, should trade at its Net Asset Value (NAV), and if a company generates profits above its cost of equity, then the stock should be valued at a premium to book NAV, because shareholder value is being added to the NAV at any given point in time, but that's a story for another day)

[I do, however, account for the concept of "ROE" in an indirect sense, and that is by monitoring how much Operating Cash Flow needs to be plowed back into a business as Capital Expenditure (aka "Maintenance", or "Sustaining", or "Stay-in-Business" Capex). It stands to reason that the higher the ratio of OCF-to-Capex, the higher will be the resulting ROE, and vice versa. So, yes, I stress that I do care about "ROE", but by its derivation in OCF/Capex in the Cash Flow Statement, as opposed to its derivation using the formula derived from P&L and Balance Sheet inputs, viz. NPAT and Shareholder Equity. Typically, if OCF doesn't cover Capex but more than 2 times, I won't invest in the stock...unless there is some other compelling valuation reason]

While I am ambivalent to ROE as derived from reported NPAT and Shareholder Equity, I am very, very concerned with the Return on MY EQUITY, i.e., the what I pay for my share in the company.

Which is why I use FCF/EV as my overarching valuation methodology, because that is the essential ROE measure (FCF being the return I receive as a shareholder, and EV being the capital that I am effectively outlaying to own the business, or a part thereof).

In other words, unless I'm buying the company at its NAV, the ROE (NPAT/Shareholder Equity) is a legacy measure that is distorted by accounting subjectivity. The Return I am to receive on the fresh Equity I invest when I buy the stock is what is vital.

It is MY ROE, as opposed to the company's ROE, that matters.

Not sure I explained myself very well here. Hope it makes just a little bit of sense.

Cameron