In looking for extraordinary businesses, there is no more important measure to a Value Investor than Return on Equity. A great company cannot be termed a great company unless it is one that consistently achieves a high ROE (>20%) over a number of years and does so employing little or no debt. ROE is the ultimate measure of the profitability of a company - how much return the company is making on its equity base.
Consider you can set-up 1 of 2 business ideas, both who produce $1M in net profit per year. Business Number 1 costs $10M to set-up, producing a return on your equity of 10%, whereas Business Number 2 costs you $5M to set-up, giving you a return on your equity of 20%. Obviously you would choose Business Number 2 because it only costs you $5M to produce the same result. This simple concept is the basis for identifying high performing companies. If a company can produce a consistently high ROE with little or no debt then that company very likely enjoys a competitive advantage and warrants consideration as an investment.
ROE vs EPS growth: In the short term at least, earnings growth largely drives share prices. But a company can always increase its earnings. For example if a company retained all earnings from the previous year, gave none out to shareholders, and put those retained earnings in a fixed interest account earning 4%, they could use that extra money and declare to the world that they have achieved a “record profit”! But this would be terrible for shareholders.
In this example, if instead of retaining the earnings, the company distributed the earnings as dividends to the shareholders, then an individual shareholder could have taken the money and invested it wisely to achieve a better return than the 4%. So in this case, by retaining all earnings, the company’s management has done a massive disservice to their shareholders. This is touching on what Warren Buffett means when he is speaking of the importance of the capital allocation abilities of management.
Another way a company can increase EPS is through acquisition. If a reasonable price is paid for an acquisition, it can both increase EPS and maintain ROE, benefiting the company and its shareholders. Unfortunately though, most of the time the result of an acquisition is a lower profitability of the parent company. Executive management love the idea of acquisitions –running a bigger ship, an increased sense of importance. Far too often though, the high price paid for an acquisition results in lower profitability (lower ROE), and once again the shareholders are wronged by management. A company whose earnings per share for the recent reporting period has risen but return on equity has fallen typically is one who has spent money on an acquisition or expansion that has provided a relatively poor return. When we say relatively, we mean relative to the return that the company was achieving prior to the acquisition or expansion. A falling ROE basically means business performance is declining, and before long the EPS and shareprice will follow.
Maintaining a high ROE is much harder for a company to do than increase EPS. This is especially true of a company that retains much of its earnings and reinvests them back in the company. Let’s say a company has $100M in equity, it achieves a ROE of 20%, and it distributes half of its net earnings to shareholders via dividends. In this case, looking 1 year ahead, the company will have $110M in equity. To maintain the 20% ROE, the company not only needs to achieve 20% return on its last years’ equity of $100M, but it also has to achieve 20% return on the $10M that was retained. So the company needs to continually employ the retained earnings in ventures which in turn provide a high return. A manufacturing company, for example, may use its retained earnings in purchasing latest technology machinery which will increase output for a lower cost. A retailer, for example, may use its retained earnings in opening a new store perhaps in a neighboring city, and that new store will provide continuing good returns.
All companies start small. The best ones grow and expand through reinvesting their earnings, as opposed to using debt. Many of the great well known American companies first used their retained earnings to expand throughout America, before expanding globally. Regardless, a company needs to make smart decisions on how its retained earnings are employed to ensure that good returns are made and high profitability, as measured by ROE, is maintained.
To take ROE a step further, Normalized Return on Equity (NROE) is where abnormal gains or losses are ignored in the calculation of net earnings. NROE is preferred over the standard ROE as it allows us to consider profits from continuing operations only.
Great companies achieve consistently high returns on equity while employing little or no debt. If a company does not display good ROE and low debt, then without exception, it is not worth consideration of investment to the Value Investor.