The perils of a too high return on equity target

One of the key decisions that businesses make is setting their hurdle rate for new investments. This is, however, trickier than it appears.

It is obvious that the hurdle rate has to be higher than the risk free rate in order to reward shareholders for the risks of operating a business, but how much higher than this should the margin be set?

It can be a particular problem for businesses that currently have very high returns on equity. In their case, even very high hurdle rates can be lower than their current ROE. This would mean that its ROE will drop over time raising concerns with analysts and investors.

It is worth reflecting on why a company might have a very high return on equity:

• It might, like Australia’s major banks, have substantial goodwill built up that it is not reflected on the balance sheet. This includes customer relationships, skilled staff, strong brands and such. Pharmaceutical and software companies can also be in a similar position.

• It might be in an industry which requires little capital to be employed, such as investment management, or providing a service, such as consulting.

• Its industry may be enjoying a temporary boom, allowing higher than normal prices to be charged.

This illustrates that very high ROEs are usually the outcome of unusual and not easily replicable circumstances.

So what are the implications of a very high hurdle rate?

• Projects will leverage off the existing good will to earn a high return on capital. This will mean that the company will stick to its knitting and be highly focussed. This may result in the company not diversifying or becoming vulnerable to a single market shift.

• Projects will be risky, as only by taking a high level of risk can the return on capital be met. If returns are not properly adjusted for risk, then increasing the risk taken on increases the expected returns. This means that, over time the business as a whole becomes riskier and its result more volatile. One way in which risk can be increased is to use gearing to reduce the required equity and enhance returns.

• Business cases get fudged. In order to get approval for a business case the figures get quietly fudged. This is done by either not fully reflecting the costs of the project ,often by underestimating or ignoring cost impacts on other parts of the business, or by overestimating the revenue impact, which can reflect complete overestimation of sales or perhaps including sales that would have been made in any case but credit them to the initiative. Another way of enhancing the numbers is to understate the equity required, for example by using a lower regulatory capital requirement, rather than a more realistic economic capital requirement.

• Sensible initiatives offering good risk adjusted returns don’t even get proposed to management as people don’t think they’ll get approved, so why bother putting together a full proposal.

Over time, these factors can seriously distort a business as the business initiative portfolio can, cumulatively have a major impact on the risk, return profile of the organisation as well as creating a more cynical, political view about business case proposals and their approval.