Every investor wants to achieve the highest possible return without taking undue risks. Investing in companies with a high Return on Equity is an excellent way to achieve this universal goal.
It seems obvious that it will be easier to make money as a share owner of a company that is making high returns rather than as a share owner of a dog company with dismal returns.
Sometimes it might be possible to make high returns on a company that is itself making little or no profit. For example if you buy a dog company at a P/E of 6 and manage to sell it soon after at a P/E of 8, because the market sentiment improves, then you will have made a 25% return. But that’s a bit like getting blood from a stone. (More likely the the market sentiment will not improve and you will not make money from a company that is not making money).
Logically, it will be a lot easier to make money from a company that is itself earning high returns and growing earnings at say 10% per year. In that case you might buy at a P/E of 15. Then you just hang on for the ride, 10 years later you can sell it at a P/E of 15 and still make a 159% gain (not coincidently a 10% compounded annual return). And if the P/E of this company rises then that is just “gravy”.
So with companies that are making high returns, you can make high returns by simply going along for the ride (buy and hold), whereas with a low return company you can only make money by outsmarting other investors.
The trick is to identify which companies are making high returns. How odd then, that investors seldom look at measures of the return that a company is making.
Return on Equity (calculated as net earning / shareholder’s equity) directly measures the returns of a company. Obviously, the higher the better. In this calculation it is very important to adjust the net earnings for any unusual gains or losses, otherwise the result will be distorted and not sustainable. It is useful to calculate return on equity for the past several years to determine an average or sustainable figure.
If a company continues to make 15% return on equity and retains all earnings and reinvests it at the same 15% return on equity, then its earnings will grow at 15% per year. If the company dividends out half its earnings then it will grow earnings at 7.5% per year. The sustainable rate of earnings growth is ROE * (1 – percent of earnings paid out as dividends).
Of course a company that makes 15% ROE this year may not make 15% next year. But if a company has been making 15% ROE for 5 or more years, and conditions have not changed then we can reasonably expect this performance to continue. Of course it will continue only temporarily, no company can forever grow faster than the economy. Or we can be more cautious and assume that future years (say the next 5 or ten years maximum) will be at least 12%. And certainly we would have more faith that this company will make 15% ROE next year as compared to some dog company that has never been higher than a 6% ROE.
Sometimes a company with low returns on equity will find a way to grow by making a good acquisition, by increasing its financial leverage or other means. That is a hopeful possibility, but a high ROE company offers a higher degree of confidence of achieving a high earnings growth.
A sustained high ROE is incredibly important because it signals that the company can sustain a high earnings growth in the short to medium term. And unless a stock starts out with an excessive P/E ratio, a high earnings growth rate must pull up the share price with a gravitational like force, over a period of years.
However, in some cases the initial P/E ratio is already pricing in all of the expected growth and more, see my article on that subject.
September 14, 2002
Shawn Allen, Editor