Return On Equity - ROE

Returns on equity play an important role in analyzing companies and putting stock prices and valuation levels in proper context. Most investors tend to concentrate on a company’s past and projected earnings growth. Even top analysts tend to fixate on bottom-line growth as a yardstick for success. However, a company’s ability to produce high returns on owner’s capital is equally as crucial to longterm growth. In some respects, return on equity may be a more important gauge of performance because companies can resort to any number of mechanisms to distort their accounting earnings.

Warren Buffett expressed this
sentiment more than 20 years ago:

“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 management
and financial analysts modified the
primary emphasis they place upon
earnings per share, and upon yearly
changes in that figure.” [From the
1979 Berkshire Hathaway annual
report.]

Buffett believes that companies that can generate and sustain high ROEs should be coveted because they are relatively rare. They should be purchased when their stocks trade at attractive levels relative to their earnings growth and ROEs because it is extremely difficult for companies to maintain  high ROEs as they increase in size. In fact, many of the largest, most prosperous U.S. companies—General Electric, Microsoft, Wal-Mart, and Cisco Systems, among them—have displayed steadily decreasing ROEs over the years by virtue of their size.

The key to understanding ROEs, Buffet notes, is to make sure that management maximizes use of the extra resources given it. Any company can continue to produce everlarger earnings every year simply by depositing its income in the bank and letting it draw interest.

“Most companies define ‘record
earnings’ as a new high in earnings
per share. Since businesses customarily
add from year to year to their
equity share, we find nothing
particularly noteworthy in a
management performance combining,
say, a 10% increase in equity
capital and a 5% increase in
earnings per share. After all, even a
totally dormant savings account
will produce steadily rising interest
each year because of compounding.”
[From the 1979 Berkshire
Hathaway annual report.]

Focusing on companies producing high ROEs, Buffett says, is a formula for success, because, as shown above, high ROEs must necessarily lead to strong earnings growth, a steady increase in shareholder’s equity, a steady increase in the company’s intrinsic value, and a steady increase in stock
price.

When evaluating two nearly identical companies, the one producing higher ROEs will almost always provide better returns for you over time.

Five other points are worth
considering when evaluating ROEs:

· High returns on equity attained with little or no debt are better than similar returns attained with high debt. The more debt added to the balance sheet, the lower the company’s shareholder’s equity when holding other factors constant because debt is subtracted from assets to calculate equity. Companies employing debt wisely can greatly improve ROE figures because net income is compared against a relatively small equity base. But high debt is rarely desirable, particularly for a company with very cyclical earnings.

· High ROEs differ across industries. Drug and consumer-products companies tend to posses higher than average debt levels and will tend to record higher ROEs. They can bear higher levels of debt because their sales are much more consistent and predictable than those of a cyclical manufacturer. Thus, they can safely use debt to expand
rather than worry about having to meet interest payments during an economic slowdown. We can attribute the high ROEs of companies such as Philip Morris, PepsiCo, or Coca-Cola to the fact that debt typically equals 50% or
more of equity.

· Stock buybacks can result in high ROEs. Companies can significantly manipulate ROEs through share buybacks and the granting of stock options to employees. In the 1990s, dozens of top-notch companies bought back stock with
the stated intention of improving earnings per share and ROEs. Schering-Plough, the pharmaceutical company, posted unusually high ROEs, in excess of 50%, during the late 1990s because it repurchased more than 150 million shares. Had Schering-Plough not been repurchasing stock, ROEs would have been between 20% and 30%.

· ROEs follow the business cycle and ebb and flow with yearly increases in earnings. If you see a cyclical company, such as J.C. Penny or Modine Manufacturing, posting high ROEs, beware. Those rates likely cannot be maintained and are probably the byproduct of a strong economy. Don’t make the mistake of projecting future ROEs based on rates attained during economic peaks.

· Beware of artificially inflated ROEs. Companies can significantly manipulate ROEs with restructuring charges, asset sales, or one-time gains. Any event that decreases the company’s assets, such as a restructuring or the sale of a division, also decreases the dollar value of shareholder’s
equity but gives an artificial boost to ROE. Firms that post high ROEs without relying on gimmicks are truly rewarding shareholders.