Today I would like to explain why so many successful investors including Warren Buffett stresses on the importance of a company having a consistent and high Return on Equity. (ROE)
Buffett’s view on Stock and Bonds
Firstly, we need to understand that Warren Buffett sees the common stock as equity bonds. The earnings per share is the equity bond yield when referring an equity bond to a common stock. So if a company has an equity value of $100 a share and earns $25 a share, the company has a Return on Equity (ROE) of 25%. (Net earnings/Equity = 25/100)
Comparing a 10 year bond which has a fixed rate of return, a common stock differs from the property of a bond in this aspect as the ROE of a company fluctuates along with its earnings. (ROE = Earnings/Equity). A shareholder’s equity is derived from a company’s total assets minus its total liabilities. Let’s bring in 2 companies: A and B.
From the table above,
Company A and B has exactly the same asset value, liabilities and shareholder’s equity value. Company A has an after-tax earnings of $1,980,000 which brings company A a ROE of 33%. On the other hand, company B has an after-tax earnings of $480,000 which brings company B a ROE of 8%.
As a shareholder of Company A, would you rather receive a dividend yield of 33% or let the management team reinvest its earnings for you to compound? Of course the latter!
What about B? Would you rather receive a dividend yield of 8% and reinvest that 8% into a more efficient company that generates a higher return on equity? Or would you rather the management team reinvest the earnings for you at a rate of 8%?
Rate of return on stocks
Warren Buffett holds his view that the rate of return of a common stock competes with the rate of return that is paid on government bonds. He opines that the government’s power to tax ensures the government bonds’ safety. And this is one of the reason the stock market goes down when the interest rates go up – simply because the return on bonds are higher now, vice versa. Assuming a common stock can get you a rate of return of 10%, it is much more attractive than a government bond rate of 5%. But when the interest rate goes up to the point when bonds have rate of return at 10%, the bonds now are much more attractive than the stock because of the ‘safety’ of bonds compared to the common stock, which has an unfixed rate of return and a higher uncertainty.
With this, let’s assume the owners of A and B liquidates both its companies and decides to put it into bonds which gives it a rate of 8%. This means that the owners do not have to undergo the trouble of running a business but still able to achieve a rate of return of 8% with the bond rate.
For the owner of company A, which is earning $1.98million a year, it would take $24.75million worth of government bonds to generate $1.98million in interest. So the owner of A is willing to sell you company A for $24.75million.
In the case of B, which is earning $480,000 a year, it would take $6million worth of government bonds to generate $480,000 in interest. So the owner is willing to sell you company B for $6million.
Look long term
If you buy A and B at the price above, both give a return of 8% in the next year. It might not be so for the subsequent years. The return by each company would be then be determined by how efficient the business is run. One important thing that I cannot emphasize more is that Warren Buffett does not focus on the following quarter or year’s earnings. He looks at what a company can generate in the next 10 years. This is different from what many analysts focuses on, which is how much can a particular company can grow with the next 12 months. This is also why a consistent and a strong Return on equity is such a vital factor to him when choosing a company.
Company A would be far more attractive than company B given that A can earn a return of 33% of its equity. This means that if the management can keep this up, the retained earnings will earn 33% as well. And with that, the equity value as well as the earnings will grow and compound.
Let’s take a look at company A’s projections of its equity value and earnings in the next 10 years, assuming that A can maintain a return of its earnings at 33%.
What you are seeing is shareholder’s equity base compounding at 33% rate of return.
Isn’t it impressive how much company A’s equity and earnings are growing? Now we know why a strong and consistent ROE is so important when choosing a company. If you paid, $24.75 million for A at the beginning of year 1 and sold it for its equity value of $103,912,000 at the beginning of year 11, you would have made an annual compounding rate of return of 15.4%!
If you sold it for $428million, the amount of the same government bonds that provides a rate of return of 8%, your annual compounding rate would be 33%!
Now let’s look at company B to see how it has performed in the next 10 years.
What you are seeing is shareholder’s equity base compounding at 8% rate of return.
If you paid, $6million for B at the beginning of year 1 and sold off at the beginning of year 11 for its equity value of $12.95million, your annual compounding rate would be roughly about 8%. Assuming the same government bond that provides a rate of return of 8% still exists, the amount of government bond it would take to earn the $1,036,000 B is projected to earn in Year 11, your annual compounding rate would still be about 8%.
Compounding interest is the 8th wonder of the world
Here is my favorite part. Suppose you only have only $6,187,500, wouldn’t it be better if you spent it buying all one Company B instead of spending it to buy 25% of A? Mathematics has shown that even 25% of A is a better investment that owning 100% of B!
If you paid $6,187,500 to buy 25% of A, and sold it for 25% of its equity value at Year 11 for $25,978,000, then your annual compounding rate of return would still be 15.4%. If you sold it for 25% of the government bond value, $107million, your annual compounding rate of return would still be approximately 33%.
By now you may have figured out that paying $24.75million, or 12.5 times earnings for A is a fantastic price to buy at, given that it is expected to receive a 33% compounding annual rate of return for the next 10 years. In fact, A may be worth a lot more to buy at! Let’s look at how much more!
If you paid $59.4million, or 30 times earnings, and held it for 10 years, selling off 12.5 times Year 11’s projected earnings of $34,291,115 (34,291,115 x 12.5 = $428,638,937), you compound annual rate of return would be 21.8%. In other words, if you bought A at a PE ratio of 30 and sold it off at a PE ratio of 12.5, your compounding annual rate of return would be 21.8%!
A little deeper…
Let’s test A a little more… (Bear with me)
If you paid $79.2million for A (PE ratio of 40) and sold it off 10 years later for $428,638,937 (PE ratio of 12.5), your annual compounding rate of return would be 18.3%!
Excellent businesses that can consistently generate high rates of ROE, are often still bargain buys even though they might seem to be overvalued given their high PE ratio! This simple example shows us why Warren Buffett is particularly interested in excellent businesses that can generate a high return of equity.
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Disclaimer: I have taken this example from a book called Buffettology by Mary Buffett. I do not claim any credit for this example. I hope this simple example convinces you to be picky when choosing which companies to buy – an excellent business with a strong management team that can generate not only a high ROE, but a consistent one as well.