How to Use ROE to Pick Stocks Like Warren Buffett – Value Investing India Report

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Bill Gates wrote an article in the Harvard Business Review titled What I Learned from Warren Buffett. He was inspired to write down his thoughts on their friendship following the publication of Roger Lowenstein’s Buffett: The Making of an American Capitalist. In the article Gates states the following:

“Warren likes to say that a good business is like a castle and you’ve got to think every day, Is the management growing the size of the moat? Or is the moat shrinking? Great businesses are not all that common, and finding them is hard. Unusual factors combine to create the moats that shelter certain companies from some of the rigors of competition. Warren is superb at recognizing these franchises.

Bill Gates, Harvard Business Review January-February 1996

Naturally, you must be wondering how exactly Warren Buffett is able to identify great businesses. The reality is that he has over decades developed a set of heuristics that allow him to make snap judgments about companies. However, one of the core ratios that he utilizes in his investment process is Return on Equity. It is an accounting identity defined as:

Net Income / Shareholders’ Equity

It is fundamentally the return achieved by equity investors on the capital invested in a business. Shareholders’ equity is defined as:

Shareholders’ Equity = Total Assets – Total Liabilities

Shareholders’ equity is also more commonly referred to as book value. Traditionally, Return on Equity is calculated using year-ending net income divided by average shareholders’ equity. Net income is found on the income statement and beginning and year-ending shareholders’ equity is found on the balance sheet. As you probably know an income statement measures profitability over a period of time. While the balance sheet measures financial data as of a single date. ROE is a measure of how efficiently a company can generate profits. ROIC is another popular measure of capital efficiency but includes the debt capital used by the business. ROE, in my opinion, better reflects the returns that are achieved by equity investors. ROE is also the single best indicator to determine whether a business has a moat as defined by Buffett. In a free market system, companies that are generating high returns on capital will eventually face significant competition causing returns to fall over time. A high ROE provides proof that a business has some form of competitive advantage in comparison to peers.

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Why is Return on Equity Important?

After reading through all of Berkshire Hathaway’s Letters to Shareholders from 1965 – 2019, it becomes clear that return on shareholders’ equity is the main profitability metric that Warren Buffett uses to measure the performance of his managers. At the end of his 1975 Berkshire Hathaway annual letter he stated the following:

“Our objective is a conservatively financed and highly liquid business – possessing extra margins of balance sheet strength consistent with the fiduciary obligations inherent in the banking and insurance industries – which will produce a long term rate of return on equity capital exceeding that of American industry as a whole.”

Warren Buffett, 1975 Berkshire Hathaway Annual Letter

It’s interesting to note that he doesn’t provide a target ROE but instead is measuring his performance relative to American industry as a whole.

Amazingly, he remained highly consistent throughout his career in terms of the criteria he used to measure business success. In the 2014 annual report, which marked the 50th anniversary of Buffett’s leadership, he stated the following:

“Berkshire’s gain in net worth during 2014 was USD 18.3 billion, which increased the per-share book value of both our Class A and Class B stock by 8.3%. Over the last 50 years(that is, since present management took over), per-share book value has grown from USD 19 to USD 146,186, a rate of 19.4% compounded annually.”

Warren Buffett, 2014 Berkshire Hathaway Annual Letter

Over a 50 year period, Warren Buffett relied on the growth in book value per share to measure his management and investing prowess.

You might be thinking that Buffett did a bait and switch. In the 1975 annual report he mentions ROE but in the 2014 report he uses book value growth as his main measuring stick for performance. However, both book value and ROE are interrelated. ROE is the key determinant in the growth of book value over time for a company.

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What is Considered a High Return on Equity

We can use DuPont analysis to breakdown ROE into the following drivers:

Net Profit Margin X Asset Turnover X Leverage

Even though two companies could have the same ROE, their operating performance could be completely different. For example, a high-end jewelry store such as Tiffany & Co. could generate a high ROE with a combination of high-profit margins, low asset turnover, and high leverage. In comparison, Walmart could also generate a high ROE but have a low-profit margin, high asset turnover, and moderate leverage. ROE is largely determined by industry-wide competitive dynamics. However, we can see from the prior example that two retailers could have opposing business models and still generate a high ROE. In his 1987 annual letter, Buffett cites a study done in Fortune magazine that found companies that could maintain an ROE above 15% produced superior stock returns. In general, a good ROE for a publicly-traded company is anything in the range of 15-20%.

The Fortune study I mentioned earlier supports our view. Only 25 of the 1,000 companies met two tests of economic excellence – an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%. These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500.

Warren Buffett, 1987 Berkshire Hathaway Annual Letter

How is ROE Related to Long-term Share Price Movement

Over time, the ROE of a stock will approximate your total return assuming (and these are big assumptions) that valuations are constant and there are no dividend distributions. Let’s assume company A was trading at INR 100, with a reported book value per share of INR 50 and EPS of INR 10. Thus, the shares are trading at a 2x P/B multiple and a 10x P/E multiple. The formula for earnings growth is ROE x (1 – dividend payout ratio), which equals 20% (20% x (1 – 0%)). Thus, next year’s earnings would be INR 12. If the P/E multiple remains constant at 10x, next year’s share price will be INR 120. Thus, the total return from the increase in share price is 20%, which is equivalent to ROE. Clearly, we’ve made some significant assumptions that valuations remain constant and that the company will never pay a dividend. In reality, valuations are highly volatile and the vast majority of companies that earn high returns on capital eventually return cash back to shareholders through either dividends or share buybacks as growth opportunities become limited. There are exceptions such as Berkshire Hathaway, which has never paid a dividend, but it proves to be the exception and not the norm. Overall, you want to own high ROE stocks as your total return over the long-term will approximate ROE.

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The mast majority of investors measure the quality of a business by the return on capital it’s capable of generating. Sustaining a high ROE is also difficult as the shareholders’ equity grows every year for a profitable company that doesn’t distribute dividends. Thus, companies that can maintain an ROE of 15% or higher can be assumed to have some form of competitive advantage, and most importantly implies that management is adepts at redeploying capital. Over time generating a high ROE becomes difficult. One only has to look at the recent performance of Berkshire Hathaway to realize that generating a high ROE becomes harder as the capital base grows, even for the most successful investor of all time. Furthermore, any management team that can sustain an ROE above 15% for a decade implies that they are not only good operators but also good capital allocators. A rare combination indeed. As investors we may never be able to develop the business judgment that Buffett has achieved. Fortunately, we can use ROE as a starting point for identifying high-quality companies that have moats and more importantly the ability to compound our wealth over time.

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Ankur Shah

Ankur Shah

Through his write-ups, Ankur teaches us to identify high-quality stocks that compound the wealth. A Harvard Business School graduate, he is the founder of the Value Investing India Report.
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