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.

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.

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Margin of Safety

Even after you think you have a good handle on what a stock should be worth, it is important to buy at a discount to this estimated fair value to give an adequate margin of safety.

After all, no projection about the future is foolproof, and protecting yourself from unforeseen events is entirely prudent.

For instance, if a company's new product falls flat and profit growth doesn't materialize, you want to be protected.

It is also important to realise that some companies are riskier and harder to predict than others.  In general, the riskier a company is, the larger the margin of safety should be.

The bottom line is that if you don't use a lot of discipline and conservatism in figuring out the prices you are willing to pay for stocks, you will regret it eventually.  

You might be able to sell some of your overvalued shares to some sucker who is willing to pay an even more inflated price, but in the end, this kind of speculating is the investing equivalent of musical chairs, with the last one holding the stock the loser.  Don't let it be you.

Buy at a price below fair value with an adequate margin of safety and sleep well at night.