Last week’s note described how companies build moats around their businesses. Two of you who read the whole thing (please come to the office and collect your prize) noticed that a good moat will translate into something called high “return on equity.” This week’s note explains why clients should be very happy they own companies with high return on equity.
Return on equity (ROE) reveals a company’s ability to turn shareholder capital into corporate profits. The metric has many champions, including Warren Buffett who wrote, “the primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed.”
ROE is often expressed as net income divided by shareholder’s equity. Net income is how much money the company makes in a year, and shareholder’s equity is the total capital contributed to the business, plus the company’s retained earnings, minus a few extraordinary items now and then. ROE is typically calculated over a one year time frame and expressed as a percentage. Some managers prefer different arrangements of the ROE formula but they all generally address the same concept.
When a company has a high return on equity, it is efficiently using shareholder money. It follows that the company is growing capital at a high rate, which should lead to an increase in stock price. If the trend in ROE is steady, it’s also likely that earnings will be steady and more predictable.
Companies that can generate and sustain high ROE are exceptionally rare. For a company to just maintain a constant ROE, it must grow earnings faster than its current ROE. This implies that profits are not just increasing, but accelerating; a very fortunate situation.
When judging ROE, most companies fall in the 10-15% area. True success stories, and Buffett’s favourites, boast yearly ROE of 15% or better. I agree.
When you find a high ROE, there are five additional points to consider:
- ROE can differ across industries. Companies with less cyclical earnings such as consumer staples tend to have higher ROE than companies with more cyclical earnings.
- Debt matters. Companies can manipulate ROE by adding debt, so high ROE from a company with little debt is more valuable than high ROE from a company with lots of debt.
- Companies can manipulate ROE through share buybacks and granting employee stock options. If a company is buying back stock because it is genuinely undervalued, this is generally a good thing.
- Be careful in projecting a company’s ROE across different business conditions. ROE will ebb and flow with recessions and booms, so investigate how a company’s ROE has performed over an earnings cycle.
- Onetime factors such as restructuring charges, asset sales, and other events can temporarily inflate/deflate ROE.
Using return on equity as part of a rules-based approach will help identify more profitable companies over time. It is a key component in determining the fundamental value of companies in the Growth Portfolio.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.