BUFFETTS BOOKS ACADEMY: ADVANCED COURSE
LESSON 29: WHAT IS RETURN ON EQUITY – WARREN BUFFETT’S FAVORITE NUMBER
LESSON SUMMARY
In this lesson, we learn that the Return on equity (ROE) offers the investor a very quick glance at whether a particular stock that he may be interested to invest in is worth it.
A prerequisite for understanding Warren Buffett’s assessment of ROE is to know how he values stocks and bonds. According to Warren Buffett, bonds and stocks can be valued similarly. The value of a bond is simply the payment of coupon and the par value in the end. While the bond can be bought at a discount or a premium (below and above par value) it cannot trade at a premium at the end of the term.
The owners of stocks do not receive fixed coupons, but receive variable dividends instead. Warren Buffett compares the par value of a bond with the book value of a stock, with the clear caveat that a stock can trade at a premium and that there is no maturity date.
To understand the implication of this, imagine a company that has a book value (or equity per share) of $10 and retain $5 in EPS one year. That would mean that the book value of that same stock increased to $15 – a 50% gain on book value. In investment terms, this is called a 50% ROE. According to Warren Buffett, this will be reflected in a 50% increase in market price:
The percentage change in book value in any given year is likely to be reasonably close to that year’s change in intrinsic value – Warren Buffett
If you compare that to a $100 book value company ($100 in equity per share), which makes $5 per share, you can only expect this company to increase its equity and therefore increase the market price by 5%. In other words the ROE is 5%.
Related Article: What Is Return on Equity?
NEW VOCABULARY
Return on Equity (ROE)
A snapshot of the companies’ ability to reinvest shareholders capital. The higher ROE the better and as a rule of thumb a sustainable ROE of at least 7-8% can be recommended. Equity is the same as book value per share, so in other words ROE tells the investor how good the company is at growing the book value, and thereby the intrinsic value, of the company.
LESSON TRANSCRIPT
Return to equity is essential to understand when to invest in stocks. Although this doesn’t substitute understanding how the intrinsic value calculator works, it gives you a much more in-depth understanding of the value of a company. The return on equity number is a quick snapshot to determine whether a company is interesting or not.
Valuing stocks is very similar to valuing bonds. In 1977, Buffett wrote an article for Fortune Magazine before he became a famous investor. The link to the article is at the bottom of the webpage. In the article, he discussed how inflation eats away bonds and equities, which is contrary to what Sherwin Williams and Benjamin Graham wrote. The article is interesting mainly for the fact that Buffett goes against Williams and Graham. In there, he talks about how he values stocks and bonds similarly. In order to understand how a return on equity works, you need to understand how Buffett values stocks and bonds.
A bond’s value is all the money you get out of a bond depending on the duration that you own it. Dealing with bonds means dealing with coupon payments that are paid semiannually. After the term expires and matures, you get your par value back. Dealing with stocks is very similar, except for a slight difference. Instead of receiving biannual coupon payments, you receive quarterly dividend payments. Instead of receiving a par value back, it’s based off the book value, so how much did the book value turn into by the time you sell the shares? If you never planned on selling, the book value will hopefully keep on growing and have an impact on the value of your pick.
A bond has a fixed coupon payment, while a stock has a variable dividend payment depending on how the company pays. Whenever the term of the bond matures, you get your par value back. With stocks, it’s indefinite, and you’re basing the value off of how the book value is growing.
When figuring out the intrinsic value calculator, both stocks and bonds use the intrinsic value calculator. It’s a very similar technique. These are important when understanding return on equity, because the book value is changing. Now, we will focus this lesson on that.
Here’s a generic company called Company ABC. It has a book value of $10 a share. Depending on how it pays dividends and how it has been growing, the city or book value determines how many people are generally willing to pay over or below the book value. How much they pay is a function of how fast they can add more money into the book value. If the book value is $10 right now, they add a dollar of book value to the company in the years’ time frame. That’s how investors determine how much they are willing to pay over or under the book value.
If Company ABC had $5 per share as the earnings, their book value could grow by $5 in a year’s time frame, because now the book value is $10. If the company doesn’t pay a dividend, all the earnings go to the equity of the business. If they have an EPS of $5 and retained all those, the book value the next year should be $15. That’s substantial growth! Going from 10$ to 15$ in one year is entirely grand. Most likely, the market will fall in that trend and the market will value the company at $15 a share. As the book value grows, the market price trends right with it. Buffett said, the change in the book value over any given year is equal to the intrinsic value change in the company.
Now, here’s a different company – XYZ. This example will highlight the importance of understanding the return on equity. Company XYZ’s book value is $100 a share and their EPS is also $5, like Company ABC. They can grow their book value at that rate. They can’t grow it any more than that. The list to expect in one year’s time now is that their book value is $100 per share. Next year, the addition to the book is $5. That’s only 5% growth. Not that much, especially when compared to ABC that grew 50%.
The highlight here is that both these companies had the exact same EPS of $5 per share, but the difference is their growth. Company ABC grew 50% and that market price is trending with that book value. The market price increased 50% from the time it was bought a year ago. Company XYZ has the same exact earnings, but they only had 5% retained and it’s because the book value was so high. Their book value was $100. The focus here is the return on equity. The equity is the book value; it’s the book value per share.
Here’s the equation for return on equity:
ROE=Net income/Shareholder’s equity
Or
ROE=EPS/BV
As you know, net income broken down to per share basis is EPS (Earnings per share). The equity broken down into a per share basis is book value. When we do that for these two companies, we know that the EPS is 5 and the book value is 10. Our return on equity was 50%. Look at company XYZ that has the same exact EPS of $5, but the book value is substantially higher at $100 a share. The best return on equity a company could get is 5%.
In conclusion, a steady or increasing Return on Equity is a company that knows how to resolve their earnings. This is important because most stocks retain their earnings in the equity of the business.
A declining return on Equity is symbolic of a management that doesn’t know how to reinvest their capital in successful assets. Companies like these should pay most of their earnings as a dividend.