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 instead. -------------------more------------------------------------ ” 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 is represented as a percentage, and tells the return shareholders receive on their investment based 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. http://www.sec.gov/Archives/edgar/data/50863/000119312513065416/d424446d10k.htm#toc424446_ 10 Shareholder Equity is on the Balance Sheet: Net Income is on the Income Statement: Using the numbers above, we can calculate Intel’s 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 a $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. Year 1 2 3 4 5 Starting $ $1,000.00 $1,030.00 $1,060.90 $1,092.73 $1,125.51 Interest % 3% 3% 3% 3% 3% Ending $ "EPS" $1,030.00 $30.00 $1,060.90 $30.90 $1,092.73 $31.83 $1,125.51 $32.78 $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 1 2 3 4 5 Starting $ $1,000.00 $1,030.00 $1,060.90 $1,092.73 $1,125.51 Interest % 3% 3% 3% 3% 3% Ending $ "EPS" ROE $1,030.00 $30.00 3.00% $1,060.90 $30.90 3.00% $1,092.73 $31.83 3.00% $1,125.51 $32.78 3.00% $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. 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. 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. 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. 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: Year ROE 2008 13.38% 2009 10% 2010 23.19% 2011 28.19% 2012 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. Here are some other companies’ numbers. Guess which two Buffett is invested in? Notice the high, consistent numbers from Coca Cola and Walmart compared to the sporadic 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 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.