Use Return on Equity (ROE) to find great stocks like Warren Buffet !

One of Warrant Buffets best criteria for picking stocks is using the Return on Equity Formula. Just take a look at the annual report of Berkshire Hathaway – the company Mr Buffet Runs – for proof of this. Under acquisition criteria number three, it states that a company must generate a good return on equity (ROE) while employing little or no debt.

So why is ROE such an important metric?

The Return on Equity reflects the management’s ability to allocate capital efficiently and effectively. It measures how much return is generated for every dollar of shareholder equity. Companies with high ROEs – greater than 155 – have the ability to generate growth without need for external financing. This gives them a huge competitive advantage!

Whilst looking at the ROE figure when researching a company to invest in, looking at the ROE in isolation can be misleading. This is why Buffet states that he wants a good return on equity AND low debt. If a company has high debt levels, this can manipulate the ROE figure and give it an artificial boost. Just look at the way ROE is calculated to understand this.

Return on Equity = Net Profit / Shareholders’ Equity x 100%

A company pays for assets either by borrowing money (debt) or by getting it from shareholders (shareholders’ equity). When a company chooses to borrow a lot of money over using shareholders’ money or the profits that it generates, liabilities increase while shareholders’ equity decreases in tandem.

When shareholders’ equity decreases, the ROE figure appears higher as now the same amount of net profit is generated using less shareholders’ equity. Even though the company can achieve a high ROE this way, it is is now exposed to more risk; banks can increase interest rates or call back the loan at any time. And if the company decides to stop using debt to finance its business, it is unable to sustain its artificially high ROE. This is why Warren Buffet states that a company should generate at least 15% ROE with little or no debt to be a good investment candidate. It shows that the company is able to achieve this figure using its own money as opposes to taking on debt and artificially inflating it.

Now that you know how the ROE works and how it is calculated you can use it to calculate the
sustainable growth rate of a company. If a company doesn’t borrow money, its maximum sustainable growth rate is the same as its ROE. Just look at the example below to see how this works.

If a company can achieve 20% ROE, this means it can generate £20 in net profit for every £100 of shareholders’ equity. If the company pays no dividends, then this £20 in net profit is retained and added to the shareholder’s equity: £100 + £20 = £120.

The following year, if the company maintains its 20% ROE, it will generate £104 in net profit on the new £120 of shareholders’ equity. As net profit has grown from £20 to £24, its annual growth rate is also 20%; the same as its ROE.

If on the other hand a company pays out a dividend every year, its maximum sustainable growth rate is reduced. The sustainable growth rate will in essence be the ROE less the dividend payout ratio.

Using the same example as above, the company makes a net profit of £20 but this time has a dividend payout ratio of 50%. This means that the company pays out 50% of its net profit to shareholders as dividends (£10). Once the dividend of £10 is paid, the company now only has £10 in retained earnings. Once again, this is added to the shareholder’s equity: £100 + £1 = £110.

The following year, if the company maintains its 20% ROE, this time it will generate in net profit on the new £110 of shareholders’ equity. As net profit has only grown from £20 to £22, its annual growth rate is now only 10% (which is 50% lower than its ROE of 20%).

As an investor, you should expect a higher dividend from companies that have low Return on Equity. As seen from the examples above, a company’s sustainable growth rate is equal to its ROE or lower. If the company generates a low ROE – say 5% – then its maximum growth rate is also 5% p.a. (or lower). At this rate of growth, Investors are better off receiving dividends and investing the money for better returns elsewhere.