In his 1978 Berkshire Hathaway Letter to Shareholders, Warren Buffett stated.
“We believe a more appropriate measure of managerial economic performance to be return on equity capital.”
Measuring the performance of management of a business is a tricky proposition as there are no direct ways to measure it. We have the overall performance of the business, of course. Additionally, we can look to return on invested capital, growth in sales or earnings, or overall business health.
With a return on equity, we have a metric that can help us measure a management’s ability to generate profits from every dollar of shareholder’s equity. After all, creating wealth from the money we invest in a company is what we are all after. We want great businesses that compound our money to generate greater returns.
This formula is great for comparing businesses in related fields, i.e. retail, tech, oil, biotech, etc. One word of caution, this formula is not perfect. There are problems with it, and we need to be aware of those when we are using these numbers to value a company.
In today’s article, we will learn the formula for return on equity, how it works, where we can find the numbers for our calculations. Also, we will get some insights from great investors who use this formula to help them find great businesses.
Today’s article will be the first in a series of articles to help us gather information to learn how to value financial institutions like banks, investment houses, and insurance companies. These can be a little more complicated, so we will take bit sized pieces to learn to steps to value these businesses.
What is Return on Equity?
According to Investopedia.
“Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders has invested.”
Pretty easy, right?
So the formula takes the net income or profit of a company and measures it against the money that we shareholders invest in their company.
I think that illustrates why this formula might be important in helping us determine whether management is doing a good job managing our invested capital.
Return on equity can be a critical weapon in our arsenal, but it is important to understand what it is and how to use it. The formula encompasses the three pillars of management; profitability, asset management, and financial leverage. Or said another way, profits, assets, and debt.
By seeing how well a management team balances these pillars gives us a great idea of whether the team can get the job done. After all, it is our money that we have invested in this company.
A final thought, Return on Equity is a quick way to gauge whether the company is an asset creator or a cash cow. With the ROE, an investor can quickly see how much cash comes from existing assets.
Let’s say the ROE is 57% like Buffett’s Berkshire Hathaway (BRK.B) then that means for every dollar invested he generates 57 cents of assets. Now that is what we are talking about!
On the flip side of that equation, a low return on equity means that the company is not generating much in the way of assets for our invested capital. If for example, the number is 8%, then the company is creating 8 cents of assets per one dollar of investments.
Ideally, we are looking for a return on equity of the 15% to 20% range or higher. Keep in mind that high growth companies are going to have ridiculously high numbers.
Return on Equity Formula
Now for the formula:
Return on Equity (ROE) = Net Income / Book Value of Equity
To break this down a little bit, we can look at each variable and determine what it equates to so we can track down the numbers.
- Net Income = Net income represents the amount of money remaining, after all, operating expenses, interest, taxes and preferred stock dividends (but not common stock dividends) have been deducted from a company’s total revenue. This value can be found on the bottom line of the income statement. Thus the reference to the bottom line when referring to revenue.
- Book Value of Equity = Often referred to as shareholder equity. It is simply the difference between total assets and total liabilities. Shareholder equity indicates the assets that a company has created. This number is on the balance sheet.
There are three ways that return on equity can be calculated.
- Using the annual numbers from the previous years 10-k
- Using the TTM (Trailing Twelve Month) numbers, which are calculated using annual reports as well as quarterly reports.
- Annualizing the numbers using the latest quarter’s results and multiplying them by four
I like to use either the annual numbers or the TTM as I feel it gives me the best idea of how the company is doing because I am using actual numbers.
Ok, let’s take a look at some examples of the return on equity.
Berkshire Hathaway Return on Equity
So, let’s take a look at the master’s return on equity, shall we?
What I will do with this first example is walk you through how I am gathering the information from the annual or quarterly reports.
All numbers unless otherwise noted will be in the millions.
Berkshire Hathaway 2016 Consolidated Statement of Earnings
Net Income = $24,074
As you can see from the report, the expenses including taxes and interest expenses are deducted from the revenue to arrive at net income.
Book Value of Equity or Shareholder Equity
Berkshire Hathaway 2016 Balance Sheet
Total Shareholder’s Equity equals $286,359, but we are going to make an adjustment to this number because there is a line item that does not pertain to our formula.
We are going to subtract the noncontrolling interests from the Total shareholder’s equity. The reason for this is because the noncontrolling interests are considered a minority interest and therefore subtracted from total shareholder equity. In accounting terms, this refers to equity ownership in a subsidiary not controlled by the parent company.
In other words, there is a part ownership of a business that Berkshire does not control and this would require the reduction of the total shareholder’s equity.
So to arrive at our total shareholder’s equity for our equation, we would subtract the noncontrolling interest and arrive at our number.
Total shareholder’s equity = $283,001
So putting it all together in our formula we would get this:
Return on equity = Net Income / Shareholder’s Equity
ROE = $24,074 / $283,001
ROE = 8.50%
So, that was surprising. I expected a little better result. Remember that we are looking for anything in the 15% to 20%, or higher.
A note about doing this with real companies.
- When we are looking deeper into the numbers with regards to the financial statements, unfortunately, not everything is going to line up neatly.