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).

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

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.

Buffett likes companies with high and increasing returns on equity (ROE)

HIGH RETURNS ON EQUITY

Buffett is interested in companies that have rights rates of earnings on equity and likes them even more where the return rates are increasing. He reasons that, with a company like this, he is better off if the company pays no or little dividends and retains the money to earn even more for its owners.

• In addition, where no dividend is received, there is no income tax payable by the shareholder. 
• Instead, the investor gets the value of the increase in value in the shares which will, eventually, rise to reflect the enhanced earnings. 
• The shareholder can then retain the shares, sell them at a time that best suits them, if they wish, and take advantage of the capital gains taxation regime.

It is why potential investors should calculate the company’s history of returns on equity and management of retained earnings.

Warren Buffett's secret - THE COMPOUNDING FACTOR

EXPLANATION

This may be old hat to some readers but it is worth remembering how compounding is one of the keys to Warren Buffett’s investment success.

The compounding factor is easy to understand. Compound interest (or compounding of earnings) is simply the ability of interest (or investment return) earned on a sum of money to earn additional interest (or investment return), thereby increasing the return to the owner of the money or investor. It works like this and we will use interest as the exemplar:

You deposit a sum of money, say $1,000, in a bank or other financial institution that earns interest at the rate of 5 per cent, payable annually. At the end of the first year, you have earned $50 and have the right to get your $1,000 back.

Suppose however that you want to invest the money long-term, for say 10 years. You now have two options.

OPTION A: TAKE INTEREST PAYMENTS

You can have the interest paid to each year, in which case you will receive $50 each year to spend or use as you wish. At the end of the 10-year period, you will get your final interest payment and your $1,000 back.

OPTION B: RE-INVEST INTEREST

You can choose to re-invest your interest and earn interest each year on the accumulated interest payments as well as on the original investment. This means that you do not get annual payments but, at the end of the 10-year period, you will get a lump sum payment of $1625. This is compound interest.

Why this much larger amount? Because your interest earns interest each year like this (calculations rounded to nearest 50 cents). 

Year	Principal sum	Interest earned	New principal sum
1	1000	50	1050
2	1050	52.50	1102.50
3	1102.50	55.00	1157.50
4	1157.50	58	1215.50
5	1212.50	61	1273.50
6	1273.50	64	1337.50
7	1337.50	67	1404.50
8	1404.50	70	1474.50
9	1474.50	74	1548.50
10	1548.50	77	1625

The higher the interest, the bigger the capital gain. At 10 per cent, the sum would increase to $2594.00; at 15 per cent, to $4055.00.

Warren Buffet is said to look at the compounding factor when deciding on investments, requiring a stock investment to show a high probability of compound growth in earnings of at least 10 per cent before making an investment decision.

COMPOUNDING AND RETAINED EARNINGS

Warren Buffett has on several occasions referred to the use by a company of its retained earnings as a test of company management. He tells us that, if a company can earn more money on retained earnings than the shareholder can, the shareholder is better off (taxation aside) if the company retains profits and does not pay them out in dividends. If the shareholder can achieve a higher rate of return than the company, the shareholder would be better off if the company paid out all its profits in dividends (taxation situation again excluded) so that they could use the money themselves.

Put simply, if a company can retain earnings to grow shareholder wealth at better than the market rates available to shareholders, it should do so. If it can’t, it should pay the earnings to shareholders and let them do with them what they wish.

 HIGH RETURNS ON EQUITY

This is why Buffett is interested in companies that have rights rates of earnings on equity and likes them even more where the return rates are increasing. He reasons that, with a company like this, he is better off if the company pays no or little dividends and retains the money to earn even more for its owners.

In addition, where no dividend is received, there is no income tax payable by the shareholder. Instead, the investor gets the value of the increase in value in the shares which will, eventually, rise to reflect the enhanced earnings. The shareholder can then retain the shares, sell them at a time that best suits them, if they wish, and take advantage of the capital gains taxation regime.

It is why potential investors should calculate the company’s history of returns on equity and management of retained earnings.

BERKSHIRE HATHAWAY AND RETAINED EARNINGS

Berkshire Hathaway does not, following Buffett’s mantra, pay dividends to its shareholders and this is one reason why its compound return over the years of Buffett-Munger management has been so high.

The downside of course is that shareholders have not received dividends, meaning, that if they were dependent on money coming in at a given time, their only recourse, in relation to their shareholding, would be to sell the shares or borrow against them.

Having regard to the huge price of a single share over the past few years, this meant that investors may have had to either keep all their shareholding or dispose of it, not always the choice they wanted. Berkshire Hathaway partly catered for this dilemma by introducing B shares, which are in essence a fractional unit of the normal shares.

A POWERFUL FORCE

When asked to nominate the most powerful force on earth, Albert Einstein is reputed to have answered ‘compound interest’. Buffett might well agree.

http://www.buffettsecrets.com/compound-interest.htm

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.



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.

ROE - Key Performance Indicator for Company Management

Introduction of ROE

Return on Equity (ROE) is a term important in shares/equity investment. The simple formula for ROE is Net Profit / Shareholdings. In short, it is measured by how strong is the top management to produce profit based on current shareholdings. In DuPont formula, it is calculated as Net Profit Margin * Asset Turnover * Equity Multiplier. I will explain to you the components one by one:


Simple DuPont Formula Explanation  

1. Net Profit Margin (Net Profit / Revenue) - This is one of the very key indicators to measure company performance. A good company with 'Monopoly' status always have a better profit margin as compared to the peer companies. It can be achieved by Economy of Scales or through operation efficiencies. When you notice that the company's profit margin is increasing, perhaps you can check whether it is due to a new product launched or operation efficiencies or due to cost control improvement etc. 
2. Asset Turnover (Revenue / Asset) - It is an indicator to show whether the company is capable to have a better turnover by selling more products with limited asset available. A low non-current asset based company can perform better than a high non-current asset based company due to its bargaining power against customer.
3. Equity Multiplier (Asset / Equity) - Sometimes a good ROE can be due to high equity multiplier. It means that the company has bigger borrowing from bank/payable/bond holders to achieve higher asset. In finance industry, the leverage can be as high as 10 times and above. You must compare the equity multiplier with its peer companies. Normally if company can achieve optimal capital structure, the WACC can be the lowest. Thus, investor can achieve higher returns.

Things to take note



It does not necessary mean that you can achieve a good returns by investing in high ROE company. However, if you can find out a company is having higher and consistent ROE as compared to
its peer company in same sector, it means that this company's management is better to produce better returns as compared to rest. You must also take into considerations the other figures such as Price per Earning ratio, Dividend yield etc.

Conclusion


By comparing ROE with peer companies, you also must take note that whether the company manipulate its annual report.  It is also good that you can do a relative comparison on P/E ratio and Dividend Yield while making investment decisions.  With a good and consistent ROE, the longer you hold the investment the better the profit you can forsee in the long run.


http://www.jackphanginvestment.com/2011/04/roe-key-performance-indicator-for.html

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.

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.

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

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

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 referred to above 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.

http://www.buffettsecrets.com/return-on-equity.htm

Why Return on Equity Is Important

Historically, one of the best ways to grow wealthy has been to own businesses that generate high returns on equity with little or no debt, paying a fair or low price for your stock. It's been an easy way to shower your family with torrents of cash.


Why Return on Equity Is Important
A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company's return on equity compared to its industry, the better. This should be obvious to even the less-than-astute investor If you owned a business that had a net worth (shareholder's equity) of $100 million dollars and it made $5 million in profit, it would be earning 5% on your equity ($5 ÷ $100 = .05, or 5%). The higher you can get the "return" on your equity, in this case 5%, the better.

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