In a research article published in the Finance Contrôle Stratégie review, Christophe Bonnet and Michel Albouy, professors of finance at Grenoble Ecole de Management (GEM), demonstrate that the 15% ROE allegedly expected by shareholders is nothing more than a myth. They reveal how opinion leaders and authoritative media have caused this legend to spread in France since the 1990s. Read on for a detailed explanation.
In simple terms, how would you describe what Return On Equity (ROE) means?
The ROE measures a company's efficiency from the shareholder's perspective. It is a vitally important ratio for any investor. In other words, what benefits are shareholders expecting to see from their financial investment?
There are several ways for shareholders to put a figure on a company's profitability. From a purely accounting point of view, the ROE refers to the net income divided by the shareholder's equity. The return from an equity investment can also be measured by comparing the share purchase price against the share sale price, while factoring in any dividends that have been paid. Finally, we talk about the "expected" return to refer to the return that the shareholder is looking to receive when evaluating an investment. As explained in our article, empirical observations have been taken over an extended period of time, and they do not provide any evidence whatsoever of an industry-standard ROE of 15%. This comes as no surprise, because in financial circles, the return depends on the level of risk.
If you invest in a project with a very low risk, you will have to make do with a low level of return. But if you invest in startups, where the failure rate is 50%, a simple calculation shows that the successful ventures will need to bring you more than twice your initial investment, otherwise your activity cannot survive!
You say that there is no such thing as an industry norm for a 15% ROE. According to your analysis, "all the empirical data available prove that such a standard does not exist. For instance, between 1980-2016, only 37% of French companies and 52% of US companies achieved a ROE in excess of 15%." Why have you decided to debunk the myth?
We were surprised at how widespread this misconception is. Not only does it receive frequent coverage by the French media and observers, but by certain academics as well. It does not make any sense for financial researchers and professionals to use a fixed and universal ROE objective. We wanted to disprove the myth about the 15% ROE. We can see that this misconception was not spread by the leading Anglo-American economic media. It appeared in France and has lingered ever since, even though its popularity has waned since the 1990s. Over time, it has morphed into a falsehood that is consistently brought up when leveling criticisms at shareholders, who are all accused of being greedy and focused on the short term!
In your article published in The Conversation, you single out French people for their lack of economic and financial culture, as well as the influence of how economic science is taught in France. Why is this misconception so specific to France?
The idea is to understand why this belief has spread across France. We have two possible explanations. First of all, several international surveys, including PISA studies, show that the French are not really savvy on economic and financial matters, and they tend to misunderstand the concepts of return and risk. It is even quite worrying that this misconception has been spread by the leading economic media outlets and certain CEOs without the benefit of any real critical analysis, as we have shown in our article!
Several reports and observers have revealed a number of gaps in the economic science programs taught at high school, including an approach that is overly focused on macroeconomics, scant interest in corporations and their constraints, a tendency to zero in on the negative aspects only, and the failure to address the concept of risk, even though it applies to every economic activity.
Our second explanation concerns France's hostile attitude towards the market economy. The level of hostility is much higher than in other countries, as highlighted by a number of international studies. We are obviously not trying to suggest that companies and shareholders should be exempt from criticism! In an age that breeds widespread mistrust and false beliefs, we thought that it would a good idea to shed greater light on the workings of corporate finance, while drawing a clearer boundary between the facts and misguided public opinion, even when criticizing capitalism!
