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Return on Equity (ROE) Tells More than EPS Growth

As another earnings season rolls around and companies EPS (Earnings Per Share) numbers are making headlines, here’s why you should pay particular attention to ROE (Return on Equity) instead.

 

“Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year
to year to their equity base, 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 earnings each year because of compounding. Except for special cases (for example, companies with
unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values),

we believe a more appropriate measure of managerial economic performance to be return on equity capital.”

– Warren Buffett 2007 letter to shareholders

 

 

 

Focus on Return on Equity, not Earnings Per Share.

 

Return on Equity is simply:

 

ROE equation

 

ROE is represented as a percentage, and tells the return shareholders receive on their investment.

 

ROE is a measure of profitability of a company. Some refer to it as a company’s “Profitability Ratio”

 

The numbers to determine a company’s Return on Equity are found on their Balance Sheet Statement and Income Statement.

Below we are using Intel’s 2012 10-k report, found here.

 

 

Shareholder Equity is on the Balance Sheet: (click images to enlarge)

Intel - Balance Sheet - Shareholders Equity

Net Income is on the Income Statement:

 

Intel - Income Statement - Net Income

 

 

Using the numbers above, we can calculate Intel’s ROE:

 

Intel ROE

 

Or about 21.5%.

 

This means that for every $10,000 invested by shareholders in Intel, the company is generating about $2,150 in profits per year.

 

The higher the percentage, the more “efficiently” the company is creating profits. In other words, a company with a higher ROE is able to make more profits per dollar invested than a company with a lower ROE.

 

 

Consider 2 companies:

 

Company A’s Net Income was $1 million.

Company B’s Net Income was $1 million.

 

So far, these companies appear to be the same. They make the same amount of profit each year.

 

However, let’s say that company A required a $10 million investment to get off the ground and running (This $10 million would be shown as the company’s initial Shareholder Equity assuming no other company debt).

 

While company B required $100 million.

 

Now is it more obvious which company is better for investors?

Company A required only a $10 million investment to generate $1 million a year in profits, while company B required $100 million to generate the same profit.

 

ROE for company A is 10%

ROE for company B is 1%

 

 

EPS Growth Compared to ROE Growth

 

Companies like to tout their EPS as the end all be all number. Very often, companies will be quick to highlight the increase in EPS numbers from last year as proof of their success.

 

 

But as Buffett pointed out in the quote above, even a simple savings account would generate an increasing “EPS” number. Consider a savings account earning 3% interest.

 

Year

Starting $

Interest % Ending $ “EPS”

1

$1,000.00

3%

$1,030.00

$30.00

2

$1,030.00

3%

$1,060.90

$30.90

3

$1,060.90

3%

$1,092.73

$31.83

4

$1,092.73

3%

$1,125.51

$32.78

5

$1,125.51

3%

$1,159.28

$33.77

If a company just put their profits in a savings account, they could easily report an increasing EPS number year after year. But would that be best for investors? Of course not.

An increasing EPS number does not necessarily tell the whole story.

 

Year

Starting $

Interest % Ending $ “EPS” ROE

1

$1,000.00

3%

$1,030.00

$30.00

3.00%

2

$1,030.00

3%

$1,060.90

$30.90

3.00%

3

$1,060.90

3%

$1,092.73

$31.83

3.00%

4

$1,092.73

3%

$1,125.51

$32.78

3.00%

5

$1,125.51

3%

$1,159.28

$33.77

3.00%

 

Adding a column from the first table, now we can see that although the “company” is seeing “record EPS”, they are not becoming better at making money, ROE is flat.

 

Of course the example above is very simplified. What happens all too often is that as a company becomes larger, (more complex, more employees, more offices, etc.) it becomes much less efficient at making a profit. It means the company may require more resources to make the same amount of profit, which may be a bad sign of long term profitability. This will be shown by a declining ROE number.

 

 

What To Look For

 

As a VERY general rule, companies with ROE of 15% or more are considered decent. Investors should also look for consistent or increasing ROE over longer periods of time.

 

But there are several factors to consider when looking at ROE.

 

Debt-to-Equity Ratio

The denominator in the equation for ROE is Shareholder Equity, which is simply assets minus liabilities. This means that as a company takes on more debt its liabilities increase, which reduces Shareholder Equity, which will increase ROE. Now obviously, if a company is taking on way too much debt that is not good… but its ROE number will look amazing.

SO before you think you found a goldmine stock with ROE of 100%, take a look at the increase in liabilities, and make sure the ROE number is not because of increasing debts. (See table below, specifically Amazon’s 2005 numbers).

 

For this reason, often it is favorable to look at a company’s ROE numbers over the past several years. This can tell investors if the earnings trend of the company is positive or negative, and can filter out individual year’s numbers that may have been out of whack because of a debt offering or 1 time event.  If over the past 10 years, the company’s ROE has steadily decreased, it means the company is not able to make money like it used to, and needs to be seriously scrutinized before invested in.

 

Lets look at Intel’s numbers:

 

INTEL roe over time

Year

2008

2009

2010

2011

2012

ROE

13.38%

10%

23.19%

28.19%

21.50%

 

The increase from the 2008/2009 recession looks promising, the most recent decline is something investors will want to keep an eye on. But if Intel can keep its ROE up over 20% for the long term, it will lead to great returns for shareholders. Personally, if a companies ROE declines but is still very high, such as greater than 20% like Intel above, it does not cause me as much concern as a company whose ROE is falling and it is low (such as falling below 10%).

Here are some other companies’ ROE numbers. Guess which two Buffett is invested in?

ROE KO AMZN WMT

Notice the high, consistent numbers from Coca Cola and Walmart compared to the sporadic (mostly declining) Amazon numbers? Its no wonder Buffet chooses companies like Walmart and Coca Cola who have returned consistently high ROE for decades.

 

Wrapping Up

 

ROE tells investors so much more than a simple EPS number. ROE gives investors a glimpse at the management’s efficiency in making profits, not just simply how much it earned. ROE gives insights on the company’s margins, revenue, retained earnings and much more.

 

ROE should be used to compare companies within the same industry. Don’t expect as much use out of it comparing Intel to J C Penny’s, because those companies have completely different business models.

 

EPS is important, but it does not tell the whole story. By looking at a company’s return on equity, investors get a much better picture of the ability for a company to make profits.

 

 

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