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ROE: Investing’s Magic Formula | “The secret to life, the universe and everything” – Douglas Adams

In Investment Theory on July 13, 2009 at 2:34 am

Ok, so maybe return on equity (ROE) isn’t the secret to life, the universe and everything. But in my opinion it is the single most important metric in investing. And it should be more widely discussed by investors, business owners and managers than it is.

A definition

Return on equity (ROE) is a simple formula. It is net income for a year divided by the average shareholders equity for that year (opening + closing / 2).

Net income represents profit after paying all expenses including income taxes. Shareholder equity represents the equity capital invested in the business plus all earnings on that capital since the business started which have not been paid out to shareholders in the form of dividends. ROE can be known by other names such as increase in book value or return on net assets. These terms refer to the same metric.

ROE tells us how much profit the business earned in relation to how much shareholder funds were required to earn that profit. According to The Motley Fool:

“By taking a year’s worth of earnings and comparing it to the amount of shareholder equity on the balance sheet, you get a measurement of how much was returned for every dollar of equity the business has created.”

Why it matters

A company with a high ROE is obviously attractive as it is able to generate more profit for a given level of equity investment. Higher ROE means more money is generated by the business that can be paid out as a dividend or reinvested to expand operations. Also, such businesses may have the ability to grow at faster rates than other businesses due to the reinvestment of retained earnings at high rates of return. (Think of a high ROE is like a super high interest rate bank account.)

ROE is also a great yardstick to use across different types of businesses so that we can compare one business or industry to another. Certainly not all businesses are created equal. Some businesses such as branded consumer products companies earn very high returns on shareholder funds. Other businesses such as airlines and automakers generally earn poor returns on shareholder funds. ROE is the great arbiter that tells the difference between a mediocre business, an average one and a great one.

Examples

A mediocre business

For Toys R Us during the period from 1995 to 2005, ROE averaged around 7%. This mediocre performance was the case despite revenue and earnings increases, market leadership in the toy industry, and a strong brand. At the end of the day, there is a lot of competition in the toy business from Wal-Mart and other retailers. Toys R Us doesn’t do something that others cannot. Thus it is unable to earn high returns on invested capital.

An average business

Similar to the mediocre business, some businesses provide a better value add but not enough to allow them to sustain an unusually high ROE. In some cases, too, their business model is capital intensive and has costs that scale with the level of revenue. Take the case of Hilton Hotels, which operates hotel chains in the medium and higher ends of the hotel business. The company is very large and not a niche player. The hotel business is very competitive and there are many participants. In order to compete, a hotel must provide a certain quality of service at a competitive price. In order to grow, more rooms must be added requiring additional capital investment. It would be unlikely that any large operator, Hilton included, would be able to command average room rate or occupancy levels above industry averages. During the period of 2000-2006, Hilton Hotels earned an ROE around 13%.

A superior business

Coca-Cola is a superior business because it is not constrained by pricing or capital investment in the same manner as most businesses. This does not mean that the company can set prices at any level it wants or that it doesn’t need to make investments in its business. But it does mean that prices do not have the same proximity to cost as in an average business. Coca-Cola, like other branded consumer products companies, has created a unique product for which customers are willing to pay a premium. A competitor may offer me a can of store brand cola for 25 cents but I would rather pay a dollar for a can of Coke. As well, many of the costs in the supply chain such as bottling, storage and product retail are not borne by The Coca-Cola Company but by bottlers and retailers. During the period from 1998 – 2008, The Coca Cola Company earned a whopping 31% ROE.

Setting a bar

So what is a good number? According to Henry Blodget, a well known securities analyst and blogger, the average ROE for companies in the S&P 500 has historically been 10-12%. In the last 15 years ROE rates have been higher and abnormally so due largely to the extended economic boom and the increased use of leverage.

Jensen Investment Management, a value oriented investment manager, comments on the importance of consistently high return on equity in their investment screening process:

“We require that each business considered have a history of at least 15% return on equity (ROE) in each of the last 10 years. This single requirement narrows the universe of publicly traded U.S. companies from 10,000 to approximately 125.”

The characteristics cited by Jenson for companies with a high ROE:

  1. Sustainable competitive advantages, or “economic moats” that surround the business.
  2. High ROE produces returns that are typically in excess of the firm’s cost of capital.
  3. High and consistent ROE companies typically create more cash than is required to fund their organic growth.
  4. Companies with consistently high ROE generally have the ability to grow at faster rates than other businesses.

Warren Buffett’s thoughts

“The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.  In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.”
Berkshire Hathaway letter to shareholders 1979

Conclusion

Use return on equity (ROE) to separate the wheat from the chaff! Use ROE as a starting point to identify great businesses. Follow up by doing individual company analysis and valuation.

In a future blog post:  ROE part 2

Breaking ROE into its components: profit margin, asset turnover and leverage.

Dealing with adjustments: goodwill (return on tangible net assets), accounting impairments, and non-operating assets

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  1. Great article Aly. I struck me when reading it that I don’t think that many small business owners take into account their ROE. (Instead ROE is more likely to be used by a passive equity investor.) Perhaps small business owners should consider it as well so that they are aware of their opportunity cost. Of course, many small businesses are often financed with $10 equity and the remainder in bank debt (perhaps with a personal guarantee), so an ROE calculation may appear inflated for sometime (assuming the business is profitable). I look forward to part 2.

    • Great point Chris! I think this scenario is pretty common for a startup; ROE will be very high in the first few years until the capital structure gets to a more normal point. I will discuss it in part 2!

  2. wonderful insight. Really enjoyed reading this blog. Keep up the good work
    and to everyone keep on learning!

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