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

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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 is 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 has 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 to 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 the YouTube 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 grow!

 

 

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 ROE 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 effect 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 buybacks 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 Google’s 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.

 

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 of course.

 

 

Do you 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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