ROE, the most important management indicator

The Return On Equity (ROE) algorithm is “net profit after tax/shareholder equity × 100%”, which is one of the few financial figures that can be used to measure the operational performance of a company’s leadership team. It represents the efficiency of the company’s profit for shareholders, and it can also be said to measure the company’s overall capital utilization efficiency. Therefore, the higher the value, the better.

Return On Equity

ROE is high correlated to CEO’s ability

Just like there are few investment books that delve into the management team of listed companies. The same is true for financial indicators. It is difficult for us to find out that financial indicators are directly related to the management team of the company, especially “a high degree of positive correlation with the operating ability of the chief executive officer.” Of course, there are many very effective financial indicators that can be used to measure the operating efficiency of different companies, such as accounts receivable turnover rate, inventory turnover rate and so on.

But those indicators may not be applicable to all industry, and secondly, you may have to calculate it yourself. Financial websites may not necessarily provide these indicators for every company. This article will propose two indicators that are easy to read immediately, and will be provided for every company on almost any financial website, applicable to all companies. I personally think that compared with other financial indicators, it is a financial indicator that can be used to measure the CEO’s ability to operate.

The algorithm for ROE is "net profit after tax/shareholders' equity × 100%", which is also one of the few financial figures that can be used to measure the operational performance of a company's leadership team.

How to calculate Return On Equity

The Return On Equity (ROE) algorithm is “net profit after tax/shareholder equity × 100%”, which is one of the few financial figures that can be used to measure the operational performance of a company’s leadership team. It represents the efficiency of the company’s profit for shareholders, and it can also be said to measure the company’s overall capital utilization efficiency. Therefore, the higher the value, the better. Since one of the chief executive’s main tasks is the effective allocation of funds, the return on equity, which can be used to measure the efficiency of capital utilization, is directly linked to the effectiveness of the chief executive’s allocation of funds.

ROE is usually not used alone, and will definitely be looked at with other indicators (for example, the leverage ratio, various debt ratios, surpluses, changes in shareholders’ equity, etc.), and it depends on the company’s long-term (for example, more than 10 years).

Most of the well-known blue-chip stocks in the US stock market have excellent long-term returns on equity. For example, the ten-year average ROE of PepsiCo (ticker: PEP) is 41.14%, and that of Coca-Cola (ticker: KO) is also 28.61%.

The pitfalls on ROE

If ROE suddenly changes significantly, you must pay attention to the following pitfalls:

  • Trap 1: Does the company use financial leverage to increase borrowing to create a higher ROE? If so, you need to carefully observe the company’s financial security indicators.
  • Trap 2: The increase in after-tax net profit will also increase ROE. It should be noted whether the increased after-tax net profit is only a one-time profit? If so, there is nothing to be happy about, because the ROE is only temporary.
  • Trap 3: Declining shareholders’ equity (the denominator of ROE will become smaller) will also cause ROE to increase. You must pay attention to whether long-term investment losses are recognized in shareholders’ equity in the current period. If it is, it is necessary to be more vigilant to avoid misjudgment.
  • Trap 4: If the decline in ROE comes from an increase in the company’s retained earnings, it is the most typical representative of a decrease in capital utilization efficiency; although an increase in retained earnings is a good thing for the company, for a growing company, it is still hoped that the company can have Good capital utilization efficiency.

Most of the above content comes from the 4-2 section of my book “The Rules of Super Growth Stocks Investing“.

Buffett on ROE

Buffett said publicly: “We judge the performance of a company depends on its ROE (excluding improper financial leverage or accounting), not the growth of earnings per share; unless it is a special situation (such as debt The ratio is particularly high or the significant assets held on the account have not been revalued), otherwise we believe that the return on equity should be a more reasonable indicator to measure the performance of the management team.”

Buffett once mentioned in his 1987 shareholder letters “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.” A ROE value that is too low indicates that the management team has not made good use of shareholders’ funds to generate income, indicating that the company’s profitability is not high.

Buffett once mentioned that by studying the data of Fortune Magazine in the past few decades, he summarized the financial figures and other information of the top 500 companies in the Fortune. I have always been dissatisfied that the media gives people or companies aliases or nicknames everywhere, like Buffett has long been dubbed the nickname of the god of stocks. From this incident, it can be seen that Buffett is also a person, not a god; he actually spent a lot of time and effort on basic analysis and research of enterprises that ordinary people do not want to do. I know that most people think that doing This kind of thing is stupid, but is Buffett stupid?

Many people use the nickname of the ‘Oracle of Omaha’ to deify him and believe that he has superpowers, which is just a special case, denying his amazing achievements. He doesn’t have Aladdin’s magic lamp, so seriously Searching for information ─ ─ Don’t forget that Buffett hardly uses a computer to assist him in researching (it’s year 1987!). It takes more effort to search through paper documents. He likes to invest in the past 10 years with an average ROE of more than 20%, and there can be no companies with an average ROE of less than 15% in a year.

Conclusion

A value that is too low indicates that the management team has not made good use of shareholders’ funds to generate income, indicating that the white point is that the company’s money-making efficiency is not high.

Disclaimer

  • The content of this site is the author’s personal opinions and is for reference only. I am not responsible for the correctness, opinions, and immediacy of the content and information of the article. Readers must make their own judgments.
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