What’s Return on Equity (ROE) and Why Does Warren Buffett Use It?

   

roe warren buffett simple money man

Warren Buffett is worth north of approximately $70 Billion. Trust me, if you continue to live below your means, save, and invest consistently you MAY get there too (maybe, hopefully, let’s just cross our fingers 🙂 Apart from only investing in businesses where he is familiar with the products or services, Mr. Buffett uses Return on Equity (ROE) as part of this investment decision making process. Mr. Buffet cares about a company that uses its money wisely and efficiently. The key being its own money and not highly leveraged or borrowed money to increase sales and assets because that increases risk.

 

ROE – Why Does It Matter?

 

ROE doesn’t care about the price of a stock. Return on Equity (ROE), which is net income/owner’s equity. This is defined as how efficiently a business is using its equity to generate or how much profit a company generates with the money shareholders have invested. Right from the start it makes sense to use this as an important measure for a stock buying decision because it shows how much management values its company. It shows that management treats the assets in its company as its own personal assets. ROE also needs to be compared between businesses in the same industry to provide pertinent information to a potential investor. So for example, ROE for Bank of America should be compared to ROE of PNC Bank.

 

 

In this You Tube video below, the author talks about book value and earnings per share. When a company keeps its earnings per share and doesn’t pay dividends it increases its book value. He examines the growth of two hypothetical companies at 50% and 5%, even though they had the same EPS, but because the second company had a higher book value (equity) to begin with, the EPS didn’t increase its growth by as much. The ROE comes into play because the growth is the ROE. He’s saying the market price of the stock is reflective on the growth/ROE of the company. So continued increase of ROE means continued increase of the stock price and thus continued gains for the investor, like Mr. Buffett. Finally he mentions that taxes are not affected because as we know Mr. Buffett usually never sells his investments. Rather he just sees how the returns of the company are being reinvested and if he is comfortable with that and the ROE it produces, he then watches the stock price continuing to growwwwww!

 

 

Buffett’s Beloved ROE in Action

 

So let’s use Facebook (FB) as an example, which does not pay a dividend as of mid-2017. Oh by the way, apart from having a FB account, I’m not associated with FB in any other way nor am I receiving any benefit monetary or otherwise by mentioning them. So now, per the YChart below, FB’s ROE has generally been rising since 2012 (its initial public offering) mixed in with some slowdown in late 2014 thru 2015:

This doesn’t necessarily mean that FB would be a stock that Mr. Buffet would like for other reasons. Per Investopedia, “Facebook is using its assets slightly less efficiently to drive sales than its competitors” and its ROE is lower compared to its competitors. At the same time, the article also states that Facebook’s assets are financed more by its equity, while its competitors use leverage; something that Mr. Buffett does not like. This is a plus point in favor of Facebook.

 

So How Can It Help Me?

 

ROE is one measurement commonly used to decide if an investment is worth purchasing. But of course it should not be the only one. As a matter of fact, it can be artificially increased as well if a company buys back shares of its stock or increases debt. This is a reason why some say ROE could be misleading if you just take it at face value: “buybacks that can have a greater affect on the equity portion of the calculation as to make the ROE result a misleading indicator on how well a company is being managed.” The article goes on to mention how IBM, Exxon Mobil, and Home Depot thru share buy backs have increased ROE significantly 70%, 39%, and 43% respectively. As in the above Facebook example, however, it did not artificially inflate its ROE by acquiring debt at least. In fact, Facebook’s current ratio (which is current assets/current liabilities) is 12.61 which is pretty good as it proves it abilities to comfortably pay its existing and low debt. Per Investopedia, Google is one of Facebook’s main competitors. So I decided to look up its current ratio which is 7.13 (almost half of Facebook). Please note that I don’t support either company, just looked up some information to see how the two companies financials compare a bit.

 

 

Finally in terms of Return on Equity, Facebook is at 21.11%, while Google is at 15.42% – all per Yahoo Finance. So in this case, Mr. Buffett would be more interested in Facebook rather than Google since he likes companies with an ROE of over 20.  I think I would be too now and this exercise is making me wonder if I should earmark some funds for a Buy in the near future, but still look at some other quantitative and qualitative factors besides ROE ofcourseJ.

 

 

So do you all use ROE in your investment decision making process? Are there any tips or advice from Mr. Buffett you’d like to share?

 

 

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Simple Money Man (SMM)

10 Comments

  1. Personally, I don’t use ROE. I use P/E10 more (shiller / cape ratio). I’m a pretty valuation-oriented guy. I’m also mostly in index funds, so barring maybe 5% in play money, I don’t dabble a whole lot in individual stocks. I used to, but lost quite a bit of money one time betting on coffee futures, to the tune of $20K =(
    You win some, you lose some.

    • Very true, so many variables go into stock investing and it’s always more of chance because it’s one company. I’ve always wanted to know about ROE and this gave me a chance to write about it to help myself and others. Thanks for stopping by!

  2. Great write up around the topic of ROE. I think my biggest take away from Buffett is continue to invest even when everything around you looks terrible and when everyone is jumping head over heels into something it may be time to re-evaluate. He’s incredibly smart and I love hearing his wisdom 🙂

    • Thank you. So much of his wisdom is easy, but HARD to implement for so many of us. I wish I had the courage like him sometimes to buy when things are terrible as you mentioned. I also like that he only invests in products or services he can understand as so many people want to get in on a hot stock, but have no idea what the company does 🙂

  3. Nice post on ROE. I am a big fan of the Oracle of Omaha. He uses basic investment principles to invest in great companies and the strategy has yielded amazing results. Today so many people are focused on using derivatives and other types of alternative investments to generate returns that they overlook the basic investing strategy that Buffet followed his whole life. My husband and I use ROE among other things to evaluate some of our stock holdings. As you summarized above, it’s a great way to see how efficiently and effectively the company is using its own cash plus that of investors. Also, like the FB and GOOGL comparison, i have been a fan of both stocks for a while, but haven’t pulled the trigger and invested yet.

    • Thanks! Oh man, I wish I invested in FB when the IPO came out a few years back. But I heard something on the radio that stock prices usually drop shortly after the offering. In this case, it went UP UP UP! Oh well. Oracle of Omaha, cool I didn’t know that was his nickname. And I don’t even bother with derivatives (just learned what I needed to know in college and for the CPA exam 🙂 They’re way too risky and unknown for me.

  4. Interesting facts about how to evaluate a company by looking at ROE.
    I’m facing a small problem, if I’m considering assets / debt ratio, considering an apartament, $10k paid down and $100k that means $100k/$90k debt, so a ratio of 1.11? Is this correct?

    • Hi, you’re debt ratio is total liabilities/total assets, so you should count all of the ones you have in factoring this decision I’d say. Some people say 25%-35% is manageable. But you want to be able to comfortably pay debts and still be able to save regularly. Thanks for stopping by!

  5. When I started I was told to look at PE ratio and take that into large consideration. I have one strategy that I play with and the rest are in index funds. It would be nice to learn more and play around! I would take Google over FB though :p

    • I look at P/E ratio as well. So many these days seem like they are inflated. I think we are headed towards a correction soon, but don’t know the triggering event(s) that will lead us there. I’m trying to move more towards index funds at a slow rate to diversify and rebalance at the same time. Maybe with an index I’ll have GOOG and FB both 🙂

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