As the world’s third-richest person and most celebrated investor, Warren Buffett attracts a lot of attention. Thousands try to glean what they can from his thinking processes and track his investments.
Well, the best way to know what Buffett is thinking next and his secrets of great investments is to read his annual letter to shareholders of Berkshire Hathaway, his insurance and investment firm.
Buffett has been writing these letters for 34 years now, and each one of them carries amazing ideas on how to become a smarter investor by just following some simple rules of investing.
One of the key rules of selecting great investments that Buffett has talked about across most of his letters is that of “good return on equity”.
This is in addition to his demands of adequate size of the company, proven management, and a reasonable valuation.
What Buffett looks for are companies that earn “good returns on equity while employing little or no debt”.
Let us now understand what makes ‘return on equity’ such an important metric Buffett uses for analyzing companies. But first let’s see what this term really means.
Return on equity
Return on equity, or ROE, is one of the most useful tools to determine how well a management creates value for shareholders. The formula to calculate ROE is:
Net Profit or Earnings or Profits after Tax is the money left over after paying all the expenses of a business. It is calculated by subtracting a company’s total expenses from total revenue, thus showing what the company has earned (or lost) in a given period of time (usually one quarter or one year).
The ‘net profit’ figure is available in a company’s Profit & Loss account, as you can see from the following snapshot from Tata Steel’s annual report.
Source: Tata Steel’s FY11 Annual Report
Equity or Shareholders’ Funds or Book Value is the money shareholders (like I and you) put in the business. In other words, it is the value of an ownership interest in a property, including ownership in a business.
The ‘equity’ figure can be found out in a company’s Balance Sheet, as you can see from the following snapshot from Tata Steel’s annual report.
Source: Tata Steel’s FY11 Annual Report
Why is ROE important?
Equity is a very important concept in financial analysis because a very rough relationship tends to exist between the amount invested in a business (equity) and its earnings.
It is true that in many individual cases we find companies with small equity earning large profits, while others with large equity earn little or nothing.
Yet, as Benjamin Graham suggests in his The Interpretation of Financial Statements, in these cases some attention must be given to the equity situation, for there is always a possibility that large earnings on equity (or ROE) may attract competition and thus prove temporary (after all, why won’t a potential competitor not want to enter a business that earns high ROE?).
So, just as a 10% return on an investment is, all other things being equal, better than a 5% return, so too with ROE – higher the better.
A higher ROE also means that surplus funds can be invested to improve business operations without the owners of the business (shareholders) having to invest more capital.
It also means that there is less need to borrow, which is a positive sign for the business.
How debt affects ROE?
As I mentioned above, a company earning higher ROE is always considered better than one that earns low ROE.
However, there is a trick companies use to artificially prop up their ROE while at the same time endangering the future returns for shareholders.
I’ve prepared this small video to explain what that trick is…
If you can’t view the video here, click here to view. And, by the way, don’t forget to turn on your speakers.
India’s ROE stars
Looking at ROE in just the latest year isn’t enough. You should view ROE from the past 5 to 10 years to get a good idea of historical performance.
Here are a few mid-size Indian companies that lead the ROE charts. Why mid-size and not large-size companies? Simply because large-size ROE wonders are already household names (like Nestle, Colgate, Titan) and you would thus ask me – “So what’s the surprise here?”
So here are some mid-size Indian companies that have been at the forefront of earning high ROE over the past 10 years, and with little or no debt on their books.
Data Source: Ace Equity, Safal Niveshak Research; D/E – Debt to Equity Ratio
What to look out for?
“How much ROE is good ROE?” you may ask.
Well, this is a fluctuating requirement. But the benchmark can be around the average rate of returns that companies earn on their own investments – which is around 15-20%.
An intelligent investor would like more than that, substantially more, preferably…but 15-20% is a good benchmark to exclude companies that fall below these levels.