Return on Shareholders' Equity

SHAREHOLDERS' EQUITY/BOOK VALUE

Balance Sheet/Shareholders' Equity
($ in millions)
Total Liabilities	$21,525
Preferred Stock	0
Common Stock	880
Additional Paid in Capital	7,378
Retained Earnings	36,235
Treasury Stock--Common	-23,375
Other Equity	626
Total Shareholders' Equity	21,744
Total Liabilities + Shareholders' Equity	$43,269

When you subtract all your liabilities from all your assets you get your net worth. If you take a company's total assets and subtract its total liabilities you get the net worth of the company, which is also known as the shareholders' equity or book value of the business. This is the amount of money that the company's owners/shareholders have initially put in and have left in the business to keep it running. Shareholders' Equity is accounted for under the headings of Capital Stock, which includes Preferred and Common Stock; Paid in Capital, and Retained Earnings. Add together Total Liabilities and Total Shareholders' Equity and you get a sum that should equal Total Assets, which is why it is called a balance sheet---both sides balance.

Why Shareholders' Equity is an important number to us is that it allows us to calculate the return on shareholders' equity, which is one of the ways we determine whether or not the company in question has a long-term competitive advantage working in its favor.

Let's check it out.

RETURN ON SHAREHOLDERS' EQUITY: PART ONE

Balance Sheet/Shareholders' Equity
($ in millions)
Preferred Stock	0
Common Stock	880
Additional Paid in Capital	7,378
Retained Earnings	36,235
Treasury Stock--Common	-23,375
Other Equity	626
Total Shareholders' Equity	21,744

Shareholders' equity is equal to the company's total assets minus its total liabilities. That happens to equal the total sums of preferred and common stock, plus paid in capital, plus retained earnings, less treasury stock.

Shareholders' equity has three sources. 

• One is the capital that was originally raised selling preferred and common stockto the public. 
• The second is any later sales of preferred and common stock to the public after the company is up and running. 
• The third, and most important to us, is the accumulation of retained earnings.

Since all equity belongs to the company, and since the company belongs to the common shareholders, the equity really belongs to the common shareholders, which is why it is called shareholders' equity.

Now if we are shareholders in a company, we would be very interested in how good a job management does at allocating our money, so we can earn even more. If they are bad at it we won't be very happy and might even sell our shares and put our money elsewhere. But if they are really good at it we might even buy more of the company, along with everyone else who is impressed with management's ability to profitably put shareholders' equity to good use. To this end, financial analysts developed the return on shareholders' equity equation to test management's efficiency in allocating the shareholders' money. This is an equation that Warren puts great stock in, in his search for the company with a durable competitive advantage, and it is the topic of our next chapter.

RETURN ON SHAREHOLDERS' EQUITY: PART Two

Calculation: Net Earnings divided by Shareholders' Equity equals Return on Shareholders' Equity.

What Warren discovered is that companies that benefit from a durable or long-term competitive advantage show higher-than-average returns on shareholders' equity. Warren's favorite, Coca-Cola, shows a return on shareholders' equity of 30%; Wrigley comes in at 24%; Hershey's earns a delicious 33%; and Pepsi measures in at 34%.

Shift over to a highly competitive business like the airlines, where no one company has a sustainable competitive advantage, and return on equity sinks dramatically. United Airlines, in a year that it makes money, comes in at 15 %, and American Airlines earns 4%. Delta Air Lines and Northwest don't earn anything because they don't earn any money.

High returns on equity mean that the company is making good use of the earnings that it is retaining. As time goes by, these high returns on equity will add up and increase the underlying value of the business, which, over time, will eventually be recognized by the stock market through an increasing price for the company's stock.

Please note: Some companies are so profitable that they don't need to retain any earnings, so they pay them all out to the shareholders. In these cases we will sometimes see a negative number for shareholders' equity. The danger here is that insolvent companies will also show a negative number for shareholders' equity. If the company shows a long history of strong net earnings, but shows a negative shareholders' equity, it is probably a company with a durable competitive advantage. If the company shows both negative shareholders' equity and a history of negative net earnings, we are probably dealing with a mediocre business that is getting beaten up by the competition.

So here is the rule: High returns on shareholders' equity means "come play." Low returns on shareholders' equity mean "stay away."

Got it? Okay, let's move on.