Showing posts with label Return on Equity. Show all posts
Showing posts with label Return on Equity. Show all posts

Sunday 14 May 2023

Warren Buffett: Earnings and not book value are what determine the value of a business.

 

 


@5.45  

Earnings are what determine value and not book value.  Book value is not a factor we consider.  Future earnings are a factor we consider.  

Earnings have been poor for many great Japanese companies.  If you think the return on equity of the Japanese companies is going to increase dramatically, then you are going to make a lot of money in Japanese stocks.  But the returns on equity of Japanese businesses have been quite low, and that makes a  low price to book ratio very appropriate because earnings are measured against books.  

A company earning 5% on book value, I do not want to buy it at book value, if I think it is going to keep earning 5% on book value.     A low price to book ratio means nothing to us.  It does not intrigue us.  In fact, if anything, we are less likely to look at something that sells at a lower value in relation to book than something that sells at a higher relation to book.  The chances are we are looking at a poor business in the first case and a good business in the second case.





Sunday 18 September 2016

How do you identify an exceptional company with a durable competitive advantage from the SHAREHOLDERS' EQUITY OF THE BALANCE SHEET?

How do you identify an exceptional company with a durable competitive advantage?

Financial statements are where you can search for companies with a durable competitive advantage that is going to make one super rich.


BALANCE SHEET

The balance sheet is a snapshot of the company's financial condition on the particular date that the balance sheet is generated.

Assets minus Liabilities = Net worth or Shareholders' Equity


Shareholders’ Equity/Book Value

Shareholders’ Equity is accounted for under the headings of
·         Capital Stock (Preferred and Common Stock);
·         Paid in Capital and
·         Retained Earnings

Shareholders’ Equity is an important number as it allows us to calculate the return on shareholders’ equity.

Return on shareholders’ equity is one of the ways we determine whether or not the company in question has a long-term competitive advantage working in it favour.


Preferred and Common Stock, Additional Paid in Capital

From a balance sheet perspective preferred and common stocks are carried on the books at their par value, and any money in excess of par that was paid in when the company sold the stock will be carried on the books as “paid in capital.”

If the company’s preferred stock has a par value of $100/share, and it sold it to the public at $120 a share, a $100 a share will be carried on the books under preferred stock and $20 a share will be carried under paid in capital. 

The same thing applies to common stock, with say, a par value of $1 a share.  If it is sold to the public at $10 a share, it will be booked on the balance sheet as $1 a share under common stock and $9 a share under paid-in capital.

Companies that have durable competitive advantage tend not to have any preferred stock. 

This is in part because they tend not to have any debt. 

They make so much money that they are self financing.

While preferred stock is technically equity, in that the original money received by the company never has to be paid back, it functions like debt in that dividends have to be paid out.

Interest paid on debt is deductible from pretax income.  

However, dividends paid on preferred stock are not tax deductible, which tends to make issuing preferred shares very expensive money.

Because it is expensive money, companies like to stay away from it if they can. 

One of the markers we look for in our search for a company with durable competitive advantage is the absence of preferred stock in its capital structure.


Retained Earnings

A company’s net earnings can either be paid out as dividends or used to buy back the company’s shares, or they can be retained to keep the business growing

When they are retained in the business, they are added to an account on the balance sheet, under shareholders’ equity called retained earnings.

If the earnings are retained and profitably put to us, they can greatly improve the long-term economic picture of the business.

To find the yearly net earnings that are going to be added to the company’s retained earnings pool, take the company’s after tax net earnings and deduct the amount that the company paid out in dividends and the expenditures in buying back stock that it had during the year.

Retained Earnings is an accumulated number, which means that each year’s new retained earnings are added to the total of accumulated retained earnings from all prior years.

If the company loses money, the loss is subtracted from what the company has accumulated in the past. 

If the company loses more money than it has accumulated, the retained earnings number will show up as negative.

Retained Earnings is one of the most important number, on the balance sheet that can help us determine whether the company has a durable competitive advantage. 

If a company is not making additions to its retained earnings, it is not growing its net worth.

If it is not growing its net worth, it is unlikely to make any of us super rich over the long run.

Simply put:  the rate of growth of a company’s retained earnings is a good indicator whether or not it is benefiting from having a durable competitive advantage. 

Not all growth in retained earnings is due to an incremental increase in sales of existing products; some of it is due to the acquisitions of other businesses. 

When two companies merge, their retained earnings pools are joined, which creates an even larger pool.

General Motors and Microsoft both show negative retained earnings.

General Motors:  it shows a negative number because of the poor economics of the auto business, which causes the company to lose billions.

Microsoft:  it shows a negative number because it decided that its economic engine is so powerful that it doesn’t need to retain the massive amount of capital it has collected over the years and has instead chosen to spend its accumulated retained earnings and more on stock buybacks and dividend payments to its shareholders.

Berkshire Hathaway:  Warren Buffett stopped its dividend payments the day he took control of the company.  This allowed 100% of the company’s yearly net earnings to be added into the retained earnings pool.  As opportunities showed up, he invested the company’s retained earnings in businesses that earned even more money and that money was all added back into the retained earnings pool and eventually invested in even more money making operations.   As time went on, Berkshire’s growing pool of retained earnings increased its ability to make more and more money.

From 1965 to 2007, Berkshire’s expanding pool of retained earnings helped grow its pretax earnings from $4 a share in 1965 to $13,023 a share in 2007, which equates to an average annual growth rate of approximately 21%.

The more earnings that a company retains, the faster it grows its retained earnings pool, which in turn will increase the growth rate for future earnings. 

The catch is, it has to keep buying companies that have a durable competitive advantage.


Treasury Stock

When a company buys back its own shares, it can do two things with them. 

It can cancel them (and the shares cease to exist) or it can retain them with the possibility of reissuing them later on (and they are carried on the balance sheet under shareholders’ equity, as treasury stock).

Shares held as treasury stock have no voting rights, nor do they receive dividends and though arguably an asset, they are carried on the balance sheet at a negative value because they represent a reduction in the shareholder’s equity.

Companies with a durable competitive advantage because of their great economics, tend to have lots of free cash that they can spend on buying back their shares. 

One of the hallmarks of a company with a durable competitive advantage is the presence of treasury shares on the balance sheet.

When a company buys its own shares, and holds them as treasury stock, it is effectively decreasing the company’s equity, which increases the company’s return on shareholders’ equity.

Since a high return on shareholders’ equity is one sign of a durable competitive advantage, it is good to know if the high returns on equity are being generated by financial engineering or exceptional business economics or because of a combination of the two.

To see which is which, convert the negative value of the treasury shares into a positive number and add it to the shareholders’ equity instead of subtracting it. 

Then divide the company’s net earnings by the new total shareholders’ equity. 

This will give us the company’s return on equity minus the effects of financial engineering.

Treasury shares are not part of the pool of the outstanding shares, when it comes to determining control of the company.

The presence of treasury shares on the balance sheet and a history of buying back shares, are good  indicators that the company in question has a durable competitive advantage working in its favour.


Return on Shareholders’ Equity

Shareholders’ equity equal to the total sums of preferred and common stock, plus paid in capital, plus retained earnings and less treasury stock.

Shareholders in a company would be interested in how good a job management does at allocating their money so that they can earn even more.

Financial analysts developed the return on shareholders’ equity equation to test management’s efficiency in allocating the shareholders’ money.   

It measures the management’s ability to profitably put shareholders’ equity to good use.

Warren Buffett use the return on shareholders’ equity in his search for the company with a durable competitive advantage.


Return on Shareholders’ Equity = Net Earnings / Shareholders’ Equity


Companies that benefit from a durable or long term competitive advantage show higher than average returns on shareholders’ equity.

Companies with no sustainable competitive advantage tend to have low returns on equity.

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 stock.

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, its shareholders’ equity may be a negative number.

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.

High returns on shareholders equity means “come play.”
Low returns on shareholders equity means “stay away.”


Leverage

Leverage is the use of debt to increase the earnings of the company.

A company using leverage can increase its earnings and its return on equity.

The problem with leverage is that it can make the company appear to have some kind of competitive advantage when it, in fact is just using large amounts of debt.

Wall Street investment banks are notorious for the use of very large amounts of leverage to generate earnings.

It creates the appearance of some kind of durable competitive advantage, even if there isn’t one.

In assessing the quality and durability of a company’s competitive advantage, avoid businesses that use a lot of leverage to help them generate earnings. 

In the short run they appear to be the goose that lays the golden eggs, but at the end of the day, they are not.

Monday 13 January 2014

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.

Saturday 25 February 2012

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 Cola45.05
American Express20.19
Gillette40.43

Wednesday 28 December 2011

The Risks of Debt-Driven Returns on Equity

The three levers of ROE are:
- net profit margin  (achieve through operational efficiency)
- asset turnover (achieve through operational efficiency)
- financial leverage (achieve through employing high debt)

But does it matter if a company's high ROE comes from high debt and not operating efficiency?

If a company has a steady or steadily growing business, it might not matter that much.

For example, companies in the consumer-staples sector, where demand is stable, can handle fairly large debt loads with little problem.  And the judicious use of debt by such companies can be a boon to shareholders, boosting profitability without unduly increasing risk.

If a company's business is cyclical or volatile in some other way, though, watch out.

The problem is that debt comes with fixed costs in the form of interest payments.  The company has to make those interest payments every year, whether business is good or bad.

When a company increases debt, it increases its fixed costs as a percentage of total costs.

In years when business is good, a company with high fixed costs as a percentage of total costs can make for a great profitability because once those costs are covered, any additional sales the company makes fall straight to the bottom line.

When business is bad, however, the fixed costs of debt push earnings even lower.  

That is why debt is sometimes referred to as leverage:  It levers earnings, making strong earnings stronger and weak earnings weaker.

When companies in cyclical or volatile businesses have a lot of leverage, their earnings therefore become even more volatile.  

So the next time you're thinking about profitability, make the distinction between the kind that is internally generated (through operational efficiencies) and the kind that is inflated by debt (through leverage).

You can make a lot of money of stocks of companies structured like the latter, but your return is more assured with stocks of companies like the former.

Financial Leverage - Lever of ROE

The three levers of ROE are net margin, asset turnover and financial leverage.

The third lever of ROE, financial leverage, is a measure of how much debt the company carries.

The way in which raising financial leverage increases ROE is a little less intuitive.

If a company adds debt, its assets increase (because of the cash inflows from the debt issuance) and so does its total debt.

Equity = Assets - Total Liabilities
Assets = Equity + Total Liabilities

Since equity is equal to assets minus total debt, a company can decrease its equity as a percentage of its assets by increasing its debt.

ROE
= Net Profit/Revenue  x  Revenue/ Asset   x   Asset/Equity
=  ROA  x  Asset/Equity

In other words, assets - the numerator of the financial leverage figure - increases, so the overall financial leverage number rises, boosting ROE.

Net Margin and Asset Turnover - Levers of ROE

The three levers of ROE are net margin, asset turnovers and financial leverage.

Not all the 3 levers of ROE are made equal.

The first two levers, net margin and asset turnover, are measures of how efficient a company's operations are.

Increasing net margins - which means a company is turning a larger portion of its sales into profits - will increase profitability.  

A high asset turnover, which expresses how many times a company sells, or turns over its assets, in a year is also a sign of efficiency.

The product of net margin and asset turnover is called return on assets, or ROA, and it is an excellent measure of operational profitability.

ROA = Net Profit Margin x Asset Turnover

The higher a company's ROA, the better.

Some companies emphasize high net margins to pump up their ROA; others emphasize rapid turnover.  

For example:

Coca Cola KO
Between 1994 and 1998, Coke's net margins averaged 18%.
Coke was able to leverage its strong brand name into higher prices, resulting in fat net margins.

Cott COTTF, a Canadian produce of discount, non-brand-name soda.
Cotts's average net margin was less than 5%.  
Cott, on the other hand, targeted the low end of the market with bargain prices, earning a slimmer profit margin on each sale but (hopefully) moving a lot more merchandise per unit of assets.

Cott's asset turnover during the same period was 1.7, compared with Coke's 1.1.  But that wasn't nearly enough to offset Coke's much higher net margins, and Coke's ROA of 24% trounced Cott's 4%.  

This is not to say that focusing on asset turnover at the expense of margins is always a bad thing.  

Wal-Mart WMT
Wal-Mart WMT has lower margins than most other major retailers because it emphasizes lower prices.  
But Wal-Mart also generates a higher ROA than most of these competitors because it operates so efficiently that its asset turnover is much higher.

In 1998, for example, Wal-Mart''s asset turnover was 2.8, as opposed to 1.1 for old-line retailer Sears S and 2.0 for rival discounter Dayton-Hudson DH.

ROE and Internet Stocks

As an example, consider the fastest growing segment of 1999, Internet stocks.

Most Internet companies are growing rapidly, but few of them are generating profits.

Life Cycle of A Successful Company

Apart from America Online AOL and its 25% ROE in 1999, none have generated a high return on capital. 


In 1999, the ROE for market darling Amazon.com AMZN was negative 270%.

  • In other words, for each dollar shareholders had invested in the company, Amazon lost $2.70.  
  • To replenish the lost capital, the company must either issue debt or turn to shareholders for more money -  and there are still plenty of people willing to pony up the money to own a piece of Amazon.  
  • If Amazon is going to justify its price, it will eventually have to generate good returns on capital, and whether it can do that depends on which pundits you listen to.  


But there is no argument that returns on capital are the engine that drives stock prices in the long run.


Companies that go on to earn good returns on capital - ROEs of more than 15% or 20% - will probably make good investments.   

Those that struggle to earn a decent return will probably be wretched investments, regardless of how fast they grow.  

So, if someone tries to talk you into investing $10,000 in a restaurant or a few hundred share of an Internet stock, don't ask how fast the company will grow.  Ask how the heck it is going to earn a good return on its capital.

Why Return on Equity Matters

Let's say you want to open a whole chain of restaurants.

In the early years of building your business empire, you will be adding to your capital base aggressively.  

But because of the costs of opening restaurants, you will probably take losses; most companies in their formative stages lose money.  

If after a few years you have sunk $500,000 into your restaurants but are losing $50,000 annually, your return on capital is negative 10%.

It is not necessarily bad for a company to earn a negative return on equity - if it can earn a high return in the future, that is.

An investor will stomach a negative 10% ROE for his restaurants if he believes they can earn much higher returns in the future.

The trouble is, in a company's rapid-growth phase, when returns on equity are most often small or negative, it is tough to separate a good business (one that can earn a high ROE) from a bad business (one not able to).  After all, each is losing money.




Analyzing such companies means asking questions like
  • "Is this a company with enough pricing power to eventually command a premium price for its product?"
  • And "Is this a company with enough of a cost advantage that it can undercut the competition?"

It means, in other words, asking whether the company's business can either generate a high net margin (profit/sales) or a high asset turnover (sales/assets), the two key components of a high return on capital. 

Return on Equity - it is the long-term return on capital that excites

The way analysts usually measure return on capital for publicly traded companies is return on equity, or ROE.  

ROE =  Net earnings / Shareholders' equity

Shareholders' equity, or equity capital = Total assets - Total liabilities

Shareholders' equity is the part of the company owned by stockholders - the capital they have invested in the company.

A company X earned an incredible 63% on its equity capital in 1999.   In other words, for every $1 of shareholder money invested in the firm, this company X generated an annual profit of $0.63.

Be careful, though.  It is easier to post a large ROE in a single year than it is to maintain that large ROE over a longer period.

Company Y, for example, earned 58% on its equity in 1999, but if you average the company's ROEs over the five-year period from 1995 to 1999, the figure drops to a much less impressive 19%.

It is that long-term return on capital that we're interested in.


Measuring Returns on Capital

What makes a company great?

It is not rapid growth.

It's not landing on a best-of-the-year list.

Rather, it is the ability to generate high returns on capital.

Suppose you decide to open a business.  The money you spend building the business is your capital.

Whether the business is a good investment depends on how much profit you make as a percentage of that capital.

If you earn a profit of $10,000 in a given year and you've invested $100,000 in building the business, you've made a 10% return on your capital.

Not spectacular, but better than a savings account.



Wednesday 3 June 2009

Return on Equity

Return on Equity

Abbreviated as ROE, refers to a measure of how well a firm used reinvested earnings to generate additional earnings, equal to a fiscal year's after-tax income (after preferred stock dividends but before common stock dividends) divided by book value, expressed as a percentage.

It is used as a general indication of the firm's efficiency; in other words, how much profit it is able to generate given the resources provided by its stockholders. investors generally look for firms with returns on equity that are high and growing.