One of Warren Buffett’s favourite methods of measuring an investment is using return on equity (ROE). Return on equity is expressed as a percentage and the formula is as follows:
ROE = Net Income / Shareholder’s Equity
It is an effective method to know how much an investor is earning with respect to the amount he has invested. Shareholder’s equity is the balance between the company’s asset and liability.
For example, Cheung Kong Holdings (1:HK), the main listed entity of Asia’s richest man, Li Ka-Shing, has a shareholder’s equity of HK$342.6 billions at the beginning of 2013. For the full year 2013, it earns a total of HK$35.97 billions. That will translate to an ROE for the year of 10.5%, quite an amazing feat for such a large company.
With the ROE, the investor can then compare it with other companies in the industry and see which companies are able to make use of its capital more effectively. Generally, it will be more useful for investors to compare the ROE between companies over a longer time period; ie 5 to 10 years. This will give a clearer view of how each company utilized its equity over time, since profitability over the short term might be due to events that are outside of the control of the management and are non-recurring in nature.
However, it is important for investors to note the difference between return on equity and return on invested capital (ROIC). It is because many companies do not trade at its book value. Software companies such as Tencent Holdings (700:HK) trades at 13.5 times its price to book ratio. Even when Tencent earns a ROE of 26.5%, for an investors who has just invested in Tencent, she would be only earnings a ROIC of 2%. ROE should always be part of an investor’s tool in valuing a company instead of the ONLY tool.
Value In Action
The ROE uses the Shareholders’ Equity as a denominator which is the residual after subtracting a company’s liabilities from its assets. It is a useful way to compare companies to analyze which of them make use of their capital more effectively than the other.
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All views and opinions articulated in the article were expressed in Stanley Lim’s personal capacity and do not in any way represent those of his employer and other related entities. Stanley Lim do not own any shares in the companies mentioned above.