Understanding ROE

 

SUMMING IT UP

If you want to use fundamental analysis effectively, you must have a clear understanding of your tools.  Currently, this can be hard to do when you are looking at ROE figures because of the inconsistencies in the measurement of ROE.

However, if it’s important to express profit margins as “gross margins,” “operating margins,” or “pre-tax margins,” then it’s equally essential to identify ROE as “net return on beginning equity,”  “EACS return on average equity,” or the like.  At least, in that scenario, anyone using those ratios  will be able to assess their shortcomings and make rational analyses and comparisons.

At a minimum, if you are analyzing a company,  you need to understand how the ROE figures weregenerated, and be aware of distortions that can occur depending on the equity figure used.

Use "normalized income after taxes."

If you are calculating ROE on your own, it should be calculated using the most “stripped-down” income available; i.e., “normalized income after taxes,” which excludes all non-recurring and extraordinary items from the income derived from continuing operations. This is not all that easy to  come by. Either you, or your data provider’s analysts must estimate the tax implications for the non-recurring items excluded, since such items appear above the tax line on the income statement. At this time, the only data providers I  know of that offer normalized earnings are Value Line (www.valueline.com) and Market Guide (www.marketguide.com).

As a practical matter, the second best and probably the “most likely to succeed” would be income available to common shares from continuing operations excluding extraordinary items. And the  net income after taxes would be a near next choice.

Best to divide income by beginning equity

The income source, so long as it’s identified, is not the crucial issue however. Far more important is that, whatever income is used, it should be divided by beginning equity in order to exclude any distortions that arise from changes to equity—especially those from the retained earnings. The concept  of return must be simple. Whatever incremental increases in income may result from the use of  that income should be regarded merely as effective utilization of the beginning equity that  produces the return.

At the very least, for those that use average or ending equity, if it’s worth the trouble to consider return on equity at all, then it’s worth the trouble to back out the items that affect changes in equity  during the period, if not the retained earnings.  The use of average equity is not good, but beats  ending equity.

Probably the least useful calculation of ROE uses earnings per share divided by ending book value, because that figure is not only distorted by all of the issues raised above, but it’s also subject to the additional inaccuracies that come from using different values for outstanding shares—e.g., diluted, average, weighted average, shares at the beginning or end of the period—to arrive at the top and  bottom of the equation.

To be useful, ROE must be calculated using components that clarify, rather than distort, the return picture. Or, at the very least, as an analyst you must be aware of those possible distortions by  being aware of the components used in the calculation. Without this awareness, I would suggest that  ROE is simply not what it’s cracked up to be. 

Warren Buffet on Equity Bonds

@0.40  Anything can happen in the market, therefore, don't borrow money to invest.
@1.39  Look at the business to see if you have made a good investment, not the price.
@3.30  Many shareholders look at Berkshire as a savings account.
@3.50  Interest rates are gravity on the stock prices.  When interest rates are so low, the stock prices are going to rise.
@4.10  30 year government bond versus equity bond (hear Warren Buffett's explanation).
@5.10  When value of government bond offers higher coupon rates, it affects the value of your equity bonds.
@5.40  The yardstick is government bond.  The higher the yardstick goes, the less attractive are these other bonds.
@5.53  In 1982/83, when the long government bond got to 15%, a company that was earning 15% on its equity was worth no more than its book value in those circumstances.  A business that was earning 12% then, was a sub-par business.  
@6.15 to 7.00  On the other hand, a business earning 12% on equity when the government bond is 3% is a fantastic business to own.
@7.10  If you told me interest rate is going to be 15% next year, there will be a lot of equity I do not wish to own.
@7.30  Idiotic to own long term bond.
@8.05  Asset allocation to bonds and stocks.  Some people should never own stocks, especially if they are emotionally or psychologically not tuned to owning them, doing something stupid.
@8.53  The longer you hold stocks, the less risky they be, the longer you hold bond, the more risky they become.
@9.22  Investing is not easy, psychologically for most people.  Some gets the message, some don't.

Which is Better: Dollars in the Hand or "in the Bush"?

Professional investment managers strongly favour corporations which can plow back a high percentage of earnings into growing their business.

Does this always pay?

Or should the investor prefer his dividends?

For every example of a company that has compounded its growth by wise investment of its cash there are several that would have done better to pass their surplus on to their stockholders.

Very rarely, one finds a management that can do both.

• For example:  Company XYZ paid out almost 70% of its earnings in dividends.  It has invested its cash flow internally to maximum advantage.  Its shareholders have had their cake and eaten it too.

Expected Profits

The normal way for management to look upon proposed investments is to estimate the expected amount of profit.

This varies from industry to industry.

In any case,it would be unreasonable to invest company funds unless the expected return was substantial.

One finds far too much reinvestment that fails to pay off.

It is difficult for management to understand that in some cases stockholders are paid off better with their company dead than alive.




Examine the past record.

Correct judgement of management policy can only come from a full understanding of the problems involved.

It will pay the investor well to look beyond the superficialities of figures showing totals put back into business by management.  

Consideration should be given to the past record.

How have plow-back expenditures actually turned out?




There is no hard-and-fast rule.

Some stockholders profited enormously by management spending.

Other stockholders suffered through management hoarding.

Many unwise investments were made by corporate management at the wrong time.

Some very wise one were made at the right time.

This is an often overlooked factor which you should include in your analysis of stocks to buy.

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.

Accounting Return on Equity

Return on Equity (ROE) measures the rate of return earned by a company on its equity capital.

It indicates how efficient a firm is in generating profits from every dollar of net assets.


The ROE is computed as net income available to ordinary shareholders (after preference dividends have been paid) divided by the average total book value of equity.

ROE
= Net Income / Average Book Value of Equity
= Net Income /[ (Book Value of Equity FY1 + Book Value of Equity FY2)/2]


An increase in ROE might not always be a positive sign for the company.

• The increase in ROE may be the result of net income decreasing at a slower rate than shareholders' equity.  A declining net income is a source of concern for investors.
• The increase in ROE may be the result of debt issuance proceeds being used to repurchase shares.  This would increase the company's financial leverage (risk).

Return on Capital Employed

For example:

Capital employed $5 million
Annual profit after tax $1 million
Return on capital employed 20%

The profit may be expressed before or after tax.

Capital employed is the net amount invested in the business by the owners and is taken from the Balance Sheet.

Many people (including Warren Buffett) consider this the most important ratio of all.

It is useful to compare the result with a return that can be obtained outside the business.

If a bank is paying a higher rate, perhaps the business should be closed down and the money put in the bank.

Note that there are 2 ways of improving the return.  In the example above:

• the return on capital employed would be 25% if the profit was increased to $1.25 million.
• it would also be 25% if the capital employed was reduced to $4 million.

The importance of high ROE when selecting your stocks for the long term (Warren Buffett)

In his newsletter to Berkshire Hathaway's shareholders in 1987, Warren Buffett wrote a brilliant piece on his focus on return of equity in his selection of his companies.  Here are some of his notes.


1.   Only 6 out of 1000 had ROE > 30% during previous decade

In its 1988 Investor's Guide issue, Fortune reported that among the 500 largest industrial companies and 500 largest service companies, only six had averaged a return on equity of over 30% during the previous decade.  The best performer among the 1000 was Commerce Clearing House at 40.2%.

(Comment:  6 in 1000 is 0.6%)


2.  Only 25 of 1,000 companies had average ROE > 20% and no year with ROE < 15%, in last 10 years.

This Fortune study also mentioned that only 25 of the 1,000 companies met two tests of economic excellence -

• an average return on equity of over 20% in the ten years, 1977 through 1986, and 
• no year worse than 15%.

These business superstars were also stock market superstars:  During the decade, 24 of the 25 outperformed the S&P 500.

(Comment:  25 in 1000 is 2.5%)

3.  Companies with durable competitive advantage

These companies have two features.

• First, most use very little leverage compared to their interest-paying capacity.  Really good businesses usually don't need to borrow.
• Second, except for one company that is "high-tech" and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seen rather mundane.  Most sell non-sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both). 

The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics.  

(Comment:  About 20 of 1,000 companies in KLSE, that is, 2%, are investable for the long term.)

4.  Quoting Buffett from his 1987 letter to shareholders of Berkshire Hathaway:

"There's not a lot new to report about these businesses - and that's good, not bad.  Severe change and exceptional returns usually don't mix.  Most investors, of course, behave as if just the opposite were true.  That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change.  That prospect lets investors fantasise about future profitability rather than face today's business realities.  For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be."

Reference:

http://www.berkshirehathaway.com/letters/1987.html

ROE as a proxy for Competitive Advantage

The DuPont formula

ROE= (Net Profit/ Sales) X (Sales/ Assets) X (Assets/ Equity)

And we are left with:   

ROE = Net Profit/ Equity

The DuPont breakdown goes on to show why ROE is such a critical ratio for analysts and investors alike. 

It basically is combination of three ratios that reflect overall profitability and efficiency of a company. 

This breakdown also shows the bearing of six factors on ROE instead of the usual two that we assume are the beginning and end of it.

ROE as a proxy for Competitive Advantage:

Consistently High RoE figures do indicate that the company has a moat. 

As seen above in the Dupont breakdown of RoE, a company can have a high RoE 

• either because it is able to sell its goods/services at a high margin 
• or because  increase its returns by either selling its products at a high rate. 

Only the third option is undesirable i.e having a high leverage which would mean high indebtedness . 

Remember, we said a consistently high levels of RoE to be construed as an evidence of a moat. 

This is because the denominator of this ratio includes shareholders equity which in turn consists of   share capital plus retained earnings (also called reserves and surplus)

Share holder's equity= Share capital + Retained earnings

Now as the company generates higher returns on equity, the profits are added to the retained earnings. 

So the denominator of ROE keeps increasing and so either the company has to

•  keep showing growth in its profits or 
• find ways to reduce the denominator. 

The company can do that by 

• either paying higher dividends 
• or buying back shares

- both strategies lead to gains for shareholders. 

http://www.investorwhiz.com/concepts/return-on-equity-roe

The Five Rules for Successful Stock Investing 7

Analyzing a Company – The Basics

Because [analyzing companies] can be a daunting task, I suggest that you break down the process into five areas:

1. Growth: How fast has the company grown, what are the sources of its growth, and how sustainable is that growth likely to be?
2. Profitability: What kind of returns does the company generate on the capital it invests?
3. Financial health: How solid is the firm's financial footing?
4. Risks/bear case: What are the risks to your investment case? There are excellent reasons not to invest in even the best-looking firms. Make sure you look at the full story and investigate the negatives as well as the positives.
5. Management: Who's running the show? Are they running the company for the benefits of shareholders or themselves?

You can't just look at a series of past growth rates and assume that they'll predict the future [...]. It's critical to investigate the sources of a company's growth rate and assess the quality of the growth. High-quality growth that comes from selling more goods and entering new markets is more sustainable than low-quality growth that's generated by cost-cutting or accounting tricks.

In the long run, sales growth drives earnings growth. Although profit growth can outpace sales growth for a while if a company is able to do an excellent job cutting costs or fiddling with the financial statements, this kind of situation simply isn't sustainable over the long haul – there's a limit to how much costs can be cut, and there are only so many financial tricks that companies can use to boost the bottom line. In general, sales growth stems from one of four areas:

1. Selling more goods or services
2. Raising prices
3. Selling new goods or services
4. Buying another company

If you don't know how fast the company would have grown without acquisitions, don't buy the shares – because you never know when the acquisitions will stop. Remember, the goal of a successful investor is to buy great businesses, not successful merger and acquisition machines.

The first component of ROA (Return on Assets) is simply net margin, or net income divided by sales, and it tells us how much of each dollar of sales a company keeps as earnings after paying all the costs of doing business. The second component is asset turnover, or sales divided by assets, which tells us roughly how efficient a firm is at generating revenue from each dollar of assets. Multiply these two together, and you have return on assets, which is simply the amount of profits that a company is able to generate per dollar of assets. Think of ROA as a measure of efficiency. Companies with high ROAs are better at translating assets into profits.

ROA helps us understand that there are two routes to excellent operational profitability: You can charge high prices for your products (high margins), or you can turn over your assets quickly.

Return on equity (ROE) is a great overall measure of a company's profitability because it measures the efficiency with which a company uses shareholders' equity – in other words, it measures how good the company is at earning a decent return on the shareholder's money.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

The best type of business to own

Businesses with Good Fundamentals - the best type of business to own


The best type of business to own is "one that over an extended period can employ large amounts of incremental capital at very high rates of return."  (Buffett)

In practice, most high-return businesses need relatively little capital.  (Buffett)

While the highest return attainable as a criterion is understandable, how capital intensive is a business is a very important consideration.

Buffett opines that between two "wonderful" busineesss one should choose the least capital intensive.  He admits that it took Charlie Munger and him 25 years to figure this out.  (Buffett).

Valuation methods

Even the best investing strategies won't help you if you don't understand the value of the investments you are making.

Without assessing the future potential of your investments, you are simply gambling by letting probability take over.

It is in the nature of investment valuation that the calculations of their value are mathematical.


Return on Investment (ROI)

This is the end result of how much money you make or lose on an investment.

ROI = (P - C) / C

P= current market price at which you sold the investment
C = cost of the investment - the price you paid for it.


Present Value

Present value is the value that an investment with known future value has at the present time.

PV = FV / [(1+r)^t]

FV= amount of money you will receive at the end of the investment's life
r= the rate of return you are earning on the investment during that time
t= the amount of time that passes (in years) between now and the end of the investment's life.

This is an extremely common calculation with bonds, since bonds are sold at the discounted rate (the present value), and you must estimate whether the market price of the bond is above or below the present value to determine whether the price is worth it.


Net Present Value (NPV)

Net present value is the sum of present values on an investment that generates multiple cash flows.

When calculating NPV, calculate the present values of each payment you will receive, and then add them together.



ABSOLUTE AND RELATIVE MODELS

The value of fixed-rate investments is easy because you have certainty regarding what you will earn.

The problems come when you start estimating the value of variable-rate investments, like stocks or derivatives.

There are many complicated methods of calculating variable-rate investments, but they fall into three categories:

Absolute
Relative, and
Hybrid


Absolute models

Liquidation value or intrinsic value

Absolute models are the most popular among investors who look for the intrinsic value of an investment, rather than attempting to benefit by trading on movements in the market.

Such models include calculations of the liquidation value of the company, often adjusted for growth over the next few years.

In other words, you start with what the company would be worth if you simply sold everything it has for the cash, then subtract the debt.

Of course, the value of companies changes over time, and the market price of stocks is often based on the future earning potential of the company, rather than its current earnings.

So, estimates of liquidation value start with the current liquidation value and then increase that value by a percentage consistent with their average past growth, or by some other estimate of their future growth.


Dividend Discount Model  (DDM)

For investors who prefer investments that yield dividends, the DDM is popular.

DDM is calculated by working out the NPV of future dividends.

If you estimate that dividends will grow over that period, simply subtract the growth rate from the rate of return in the NPV calculation.

NPV = Dividend / (R - g)

R= discount rate
g= growth rate

For dividend investors, if the NPV of the dividends is lower than the current market price per share of the stock, the stock is undervalued, making it a great deal.


Relative Models

Relative models are popular among traders, who invest based on short-term movements in the market because they allow them to compare the performance of various options.

Common tools in performing these comparative assessments use the financial statements of a company and include:

Price to earnings ratio (P/E)

This functions as an indicator of the price you are paying for the profits a company will earn for you, either as dividends or through the investment of retained earnings.

Return on equity (ROE) = Net Income / Shareholder Equity

This indicates the amount of money a company makes using the money shareholders have invested in the company.

Operating margin = Operating Income / Net Sales

This indicates how efficiently a company is operating.


These indicators are not calculations of company value, but indicators of the comparative performance of companies in which one might invest.



Hybrids

Absolute and relative models are combined to create hybrids that attempt to estimate the value of a stock by combining the intrinsic value of the company with how well it performs compared to other potential investments.

Investment in Giant Enterprises. But how successful are they from the standpoint of the investor?

Let us take a look at the top listed companies in the stock market with either the highest assets or highest sales.  All of these enterprises have achieved enormous size, and by that token they have presumably made a great success.

But how successful are they from the standpoint of the investor?

What do you mean by success in this context?

 "A successful listed company is one which earns sufficient to justify an average valuation of its shares in excess of the invested capital behind them."

This means that to be really successful (or prosperous) the company must have an earning-power value which exceeds the amount invested by and for the stockholder.


$$$$$$


It is evident from an analysis that the biggest companies are not the best companies to invest in, based on the percentage earned on invested capital.

It is equally true that small-sized companies are not suited to the needs of the average investor, although there may be remarkable opportunities in individual concerns in this field.

There is some basis here for suggesting that defensive investors show preference to companies in the asset range between $50 million and $250 million, although we have no idea of propounding this as a hard-and-fast rule.


Benjamin Graham
The Intelligent Investor

Return on Equity (ROE) - the financial metric that investors should use to judge a company's annual performance

Buffett considers earning per share a smoke screen.

Most companies will retain a portion of their previous year's earnings as a way to increase their equity base.

Warren Buffett believes there is nothing spectacular about a company that increases earning per share by 10% if, at the same time, the company is growing its equity base by 10%.

He says this is no different than putting money in a savings account and letting the interest accumulate and compound.

Buffett prefers return on equity to earnings per share when analyzing a company.

He will make appropriate adjustments to the reported earnings to give a clear picture of how returns were generated as a return on business operations.

Buffett believes a business should achieve good return on equity while employing little or no debt.

Most investors judge annual performance by focusing on earnings per share.

According to Buffett, the proper way to judge a company's performance is though focusing on return on equity.

Return on equity is a better measure of annual performance because it takes into consideration a company's growing capital base.

Buffett uses ROE as his preferred financial metric to judge a company's annual performance; investors should do likewise.

Corporate Finance - Earning Growth Rate and Dividend Growth Rate

 Calculating a Company's Implied Dividend Growth Rate

Recall that a company's ROE is equal to a company's earnings growth rate (g) divided by one minus a company's payout rate (p).

Example:Let's assume Newco's ROE is 10% and the company pays out roughly 20% of its earnings in the form of a dividend. What is Newco's expected growth rate in earnings?

Answer:g = ROE*(1 - p)
g = (10%)*(1 - 20%)
g = (10%)*(0.8)
g = 8%

Given an ROE of 10% and a dividend payout of 20%, Newco's expected growth rate in earnings is 8%.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/dividend-growth-changing-dividend-policy-effects.asp#ixzz1yf57n9sb

Wise Use of Retained Earnings

SPLITTING COMPANY PROFITS

When a corporation makes a profit, it can spend that profit in two ways:

a) return the profits to stockholders by way of dividends, share buy-backs or bonus issues;

b) use the money to increase the profitability of the company

For example, a company makes a profit of $100. 

• It can pay this entire amount to stockholders who can then use that money as they think fit – spend on consumer items, make further investments, whatever. 
• Or the company can use all that profit to invest in the business with a view to increasing profits in future years. 
• Or the company can do a bit of both.

WISE USE OF RETAINED EARNINGS INTERESTS WARREN BUFFETT

To Warren Buffett, the ability to use retained earnings wisely is a sign of good company management. If the company management cannot do any better with earnings than he can, then he is better off if the company pays him the full amount in dividends.

Warren Buffett on Retained Earnings: For every dollar retained, at least one dollar of market value will be created for owners over 5 years.

WARREN BUFFETT ON RETAINED EARNINGS

In 1984, Warren Buffett made these comments:

‘Unrestricted earnings should be retained only where there is a reasonable prospect – backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.’

WARREN BUFFETT’S TEST FOR RETAINED EARNINGS

The test for Warren Buffett is whether company management can transform each dollar of earnings retained into no less than a dollar of market value. The period he implies that he uses is 5 years (on a rolling basis).

Using the retained earnings profitably is not enough for Warren Buffett. 

• The retained earnings must increase earnings substantially. 
• After all, just leaving the earnings in a savings account will increase earnings without any effort.

Warren Buffett has suggested to investors that they need to predict, after reasoned analysis, what rate of return a company will average over the near future. The rest is simple.

‘You should wish your earnings to be re-invested [by the company] if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of re-investment.’

Buffett would always take rates of return on total capital into account

RETURN ON CAPITAL IS VERY IMPORTANT

The example early on this page shows that debt financing can be used to increase the rate of return on equity. This can be misleading and also problematical if interest rates rise or fall. This is probably one reason why Warren Buffett prefers companies with little or no debt. The rate of return on equity is a true one and future earnings are less unpredictable. 

A careful investor like Buffett would always take rates of return on total capital into account. The average rates of return of capital in the companies in Berkshire Hathaway portfolio are:

Coca Cola	39.12
American Express	13.68
Gillette	25.93

A comparison of the rates of return on equity and capital for these three companies is significant and the reader can make their own calculations.

COMPANY RATES OF RETURN ON EQUITY

It is significant that the majority of companies in the Berkshire Hathaway portfolio in 2002 all had higher than average returns on equity over a ten-year period. For example:

Coca Cola	45.05
American Express	20.19
Gillette	40.43

Warren Buffett favours companies that increase their ROE or which have consistent levels of ROE.

INVESTMENT DANGERS

There can be dangers in averaging returns over a long period. A company might start with high rates which then fall away, but still have a healthy average. Conversely, a company might be going in the opposite direction. 

As Warren Buffett looks for predictability in a company’s earnings, one would imagine that he would favour companies who increase their ROE or which have consistent levels.

COMPANY ANNUAL RATES OF RETURN

Compare the annual rates of return on equity of the following companies, using summary figures provided by Value Line.

Year	Coca Cola	Gap Inc	Wal-Mart Stores
1993	47.7	22.9	21.7
1994	48.8	23.3	21.1
1995	55.4	21.6	18.6
1996	56.7	27.4	17.8
1997	56.5	33.7	19.1
1998	42	52.4	21
1999	34	50.5	22.1
2000	39.4	30	20.1
2001	35	4.3	19.1
2002	35	13.1	20.4

What rate of ROE does Warren Buffett look for?

WHY WARREN BUFFETT THINKS THAT RETURN ON EQUITY IS IMPORTANT

Just as a 10% return on a business is, all other things being equal, better than a 5% return, so too with corporate rates of returns on equity. 

• Also, a higher return on equity means that surplus funds can be invested to improve business operations without the owners of the business (stockholders) having to invest more capital. 
• It also means that there is less need to borrow.

WHAT RATE OF RETURN ON EQUITY DOES WARREN BUFFETT LOOK FOR?

This is a fluctuating requirement. 

• The benchmarks are the return on prime quality bonds and the average rate of returns of companies in the market. 
• In 1981, Buffett identified the average rate of return on equity of American companies at 11%, so an intelligent investor would like more than that, substantially more, preferably. 
• Bond rates change, so the long-term average bond rate must be considered, when viewing a long-term investment.
• In 1972, Buffett implied that a rate of return on equity of at least 14% was desirable. 

Although, at times, Warren Buffett has appeared to downplay the importance of Return on Equity, he constantly refers to a high rate of return as a basic investment principle.

COMPANY RATES OF RETURN ON EQUITY

It is significant that the majority of companies in the Berkshire Hathaway portfolio in 2002 all had higher than average returns on equity over a ten-year period. For example:

Coca Cola	45.05
American Express	20.19
Gillette	40.43

Why Warren Buffett thinks that ROE is Important

Warren Buffett believes that the return that a company gets on its equity is one of the most important factors in making successful stock investments.

DEFINING EQUITY

Benjamin Graham defines stockholders equity as:

‘The interest of the stockholders in a company as measured by the capital and surplus.’

CALCULATING OWNER’S EQUITY

Investors can think of stockholders equity like this. An investor who buys a business for $100,000 has an equity of $100,000 in that investment. This sum represents the total capital provided by the investor.

If the investor then makes a net profit each year from the business of $10,000, the return on equity is 10%:

10,000 x 100
  100,000

If however the investor has borrowed $50,000 from a bank and pays an annual amount of interest to the bank of $3500, the calculations change. The total capital in the business remains at $100,000 but the equity in the business (the capital provided by the investor) is now only $50,000 ($100,000 - $50,000).

The profit figures also change. The net profit now is only $6500 ($10,000 - $3,500).

The return on capital (total capital employed, equity plus debt) remains at 10%. The return on equity is different and higher. It is now 13%:

6,500 x 100
  50,000

The approach to financing its operations by a company can obviously affect the returns on equity shown by that company.

WHY WARREN BUFFETT THINKS THAT RETURN ON EQUITY IS IMPORTANT

Just as a 10% return on a business is, all other things being equal, better than a 5% return, so too with corporate rates of returns on equity. 

• Also, a higher return on equity means that surplus funds can be invested to improve business operations without the owners of the business (stockholders) having to invest more capital. 
• It also means that there is less need to borrow.