Stockpicking

Picking a good company - High return on shareholder's equity

OK, few more lessons and you will be ready to get into the head of Warren Buffett.
The return on shareholder's equity i.e. ROE (return on equity) tells you how fast a given company is growing. This will also help you determine if, in the next 10 years that company will be a good investment. This will also help us compare companies and determine which is better i.e. which will be worth more and earn more in the future.

For example, if we have a company that is earning 10 USD a share and the Shareholders equity value is worth 100 USD than we say that the company has a ROE of 10 %.

You are probably wondering, what is this shareholder's equity. Well, its just the company's assets less its liabilities. We just deduct the company's debt from its assets. Lets see what it looks like on an example:

1. If we have a house worth 200 000 USD, we close the deal by investing 50 000 USD and borrowing 150 000.
2. Let's say we want to rent the house.
3. If we do so we get a certain amount of money, if we deduct the amount we have to pay for mortgage every month we get, say, net earnings of 5 000 USD a year.
4. So, if we invested 50 000 then the earnigs = 5 000 is our annual earnings of 10% (5 000% / 50 000% = 10 %).

Similarly, is we have a company worth 10 milion in asset and 4 million in liability then the shareholder's equity is worth 6 million. If it earns 1,980,000, we calculate than its shareholder's equity is 33% (1,980,000/6,000,000 = 33%). By contrast, company B has 6 million in asset but earns only 480 000, then company B has a return on

shareholder's equity of 8 % (480 000 / 6 000 000 = 8 %). It is clear that company A is far more profitable than company B. We are going to be better off investing in company A than B.

Now let's go a step further. Just as Buffett we're not that much interested in what the company will be earning next year, we want to know how much it will earn in, say, 10 years. To do that we need to make a simple calculation. First we need to calculate what is the return on investment in the first year (see chapter 1), using the company's value relative to treasury bond's return on investment (chapter 2).

So, let's say that:
0. Company A has a ROE (return on shareholder's equity) of 33%
1. government bonds pay us a rate of return of 8%,
2. company A is making 1,98 million a year.
3. so we would need 24,75 million of government bonds to generate 1,98 million in interest (calculations regarding this bond - stock price relationship are here)
4. therefore, if the company has shareholder's equity of 6 million, we pay four times that amount for the company (24,75 million) or 12,5 its current earnings of 1,98 million.
5. our initial rate of return is 8% (1,98 million divided by 24,74 million).

If we run the same calculations for company B we get

0. Company B has a ROE (return on shareholder's equity) of 8%
1. government bonds pay us a rate of return of 8%,
2. company B is making 480 000 a year.
3. so we would need 6 million of government bonds to generate 1,98 million in interest (this simple calculation is explained here)
4. therefore, if the company has shareholder's equity of 6 million, we pay one time that for the company (6 million) or 12,5 its current earnings of 480 000.
5. Our initial rate of return is 8% (480 000 divided by 6 000 000).

Ok, sooo, that was a lot of numbers, I tried to keep it as simple and concise as possible. What you need to take out of the above is this:

Both companies give as an initial rate of return of 8% (see point number 5). But as we said earlier, we are not interested (neither is Buffett) in the next year what we are interested in is that both companies will be earning (or will be worth) in 10 years time. And here is the kicker! Although at first glance both companies are only slightly different and both will earn us 8% in the first year, company A turns out to beat company B by a long margin in ten year's time. Check this out:

Earnings of company A which has a 33% Return on Equity
Year 1 - 1,980,000
Year 2 -
Year 3 - 3,502,422
Year 4 -
Year 5 -
Year 6 - 8,239,927
Year 7 -
Year 8 -
Year 9 -
Year 10 - 25,782,793
Year 11 - 34,291,114

...and here are the earnings of compay B with a Return on Equity of 8%


Year 1 - 480,000
Year 2 -
Year 3 - 560,000
Year 4 -
Year 5 -
Year 6 - 710,000
Year 7 -
Year 8 -
Year 9 -
Year 10 - 960,000

Company A has its earnings growing much faster than Company B.

Similarly the so called equity base (company's assets in general that help the company make money) grow faster in Company A than in Company B. This is pretty straightforward, company A just gets better and bigger faster than B.
Company A euqity:

Year 1 - 6,000,000

Year 10 - 78,129,675

Company B euqity:

Year 1 - 6,000,000

Year 10 - 11,990,000

So now we might assume that company A is worth more than 12,5 times its earnings. Who knows, maybe we should not pay twelve time its year 1 earnings (24,7 million)or thirty times year 1 earnings (59,4 million)?

If we then after 10 years sell that company A for 12,5 times its earnings (at Year 11) we end up with sell price of 428,638,937 USD i.e. 34,291,114 USD X 12,5. That is an annual compounding rate of return of 21,8%. Pretty great.

So we see that decent companies with high rate of return on equity can look very nice even at price to earnigs ratios that seem high. In fact, these companies may be bargains at those valuations.
Coke had a ROE of about 33% with 100,000 worth of stocks balooning to 1,100,000 USD between 1988 and 2000.

In the next chapter we'll dig into some more coca cola analysis and try to explain how Buffett made his fortune.