High steady ROE and increasing ROE

Many investors, Warren Buffett himself included, get pretty excited when they see steady ROE over a number of years, particularly when already at a high level, say, greater than 15 percent.


Why?


ROE is defined as net earnings divided by owner's equity. What happens to net earnings, each year, in well-managed companies? They become part of owner's equity as retained earnings. Then, over time, the denominator of the ROE equation goes up, as earnings become equity (unless a portion of earnings are paid out as dividends).


That brings the following important observations:

• Maintaining a constant ROE percentage requires steady earnings growth.


• A company with increasing ROE, without undue exposure to debt or leverage, is especially attractive.

On the surface, a steady ROE would appear to indicate a ho-hum business. Same old, smae old, year in and year out. But the truth as illustrated is quite different. One can be excited that the business is growing to stay the same, as evidenced by a high constant ROE. :-)

ROE vs Earnings Growth Rate (EPSGR)

In fact, over time, ROE trends towards the earnings growth rate of the company.

A company with a 5 percent earnings growth rate and a 20 percent ROE today will see ROE gradually diminishing toward 5 percent.


A company with a 20 percent earnings growth rate and a 10 percent ROE will see ROE move toward 20 percent, as the numerator grows faster than the denominator.


Also read:
ROE versus ROTC
****Stock selection for long term investors