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w w w . t i c o n l i n e . c o m |
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RETURN ON EQUITY |
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w w w . t i c o n l i n e . c o m |
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RETURN ON EQUITY |
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Return on equity. Why is this concept so important and why does Warren Buffett mention it in over half of his Chairman's Letters to Shareholders since 1977 ('77, '78, '79, '80, '81, '85, '87, '89, '90, '91, '94)? |
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Although not as popular as the P/E ratio or as esoteric as the 'beta', it is by far the most important indicator of a company's ability to produce a real return for investors. It is the sole reason an investor invests in a company. Without sufficient returns on shareholder equity, a company's returns are destined to wallow in the depths of mediocrity or to be killed during periods of high inflation. "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." Return on equity represents the amount of earnings produced per dollar of shareholder ownership (net income divided by shareholder equity). In order to visualize this, let us create a fictional business, one in which you purchased a building and rented it out to individuals for a monthly fee. This building cost you $100,000. Let's say that at the end of the year, you managed to fill up all your rooms, and took in $50,000 for your troubles. However, you encountered adjustments that you expect to make annually (replacing light bulbs, repairing leaky faucets, mortgage costs, depreciation, property tax etc.) These adjustments reduce your take by $25,000 and you are left with $25,000 in net income. This gives you a return on equity of 25% ($25,000/$100,000). By examining a business in terms of returns on shareowner equity one wonders why investors put up with lower-returning companies. All things being equal, if you had to invest $100,000 in a business would you want to net $25,000 or $5,000 per year? The answer should be obvious. "In its 1988 Investor's Guide issue, 'Fortune'
reported
that among the 500 largest industrial companies and 500 largest service companies
, only six had averaged a return on equity of over 30% during the
previous decade."
However, high returns on equity are difficult to achieve year in and year out. Managers may be able to achieve great returns in one year or maybe even two, but to maintain such a high efficency for 9 or 10 consecutive years is an extremely difficult task indeed. Let us take the above example to see how it can be tiring to maintain high returns on equity. Let us take your $100,000 business. If you achieved a 25% return on equity, you would have net $25,000 in that year. If that amount dropped straight into your equity pool, your equity base for the next year would be $125,000 and in order to maintain the same 25% return on equity the following year you would need to make $31,250 - over $6,000 more than the previous year! As you can see, a high return on equity is a double-edged sword, although great for the investor, it forces the manager to clear a bar that is continually raised year after year! That is why Warren Buffett considers returns on shareholder equity to be the most valuable measure of managerial economic performance. A manager that can consistently earn high returns on equity is definitely worth paying for, otherwise, why bother? Cheers, |
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