In this article, we'll explore the relationship between growth and return on equity (ROE) and how they impact the economic value of a business. We'll break down this concept using two hypothetical companies, Berkshire and Hathaway, to illustrate the significance of these factors on a business's value. By understanding how growth and ROE interact, we can gain insights into making informed investment decisions.
But first, let's consider ROE itself. Return on equity concentrates exclusively on how good, or otherwise, management is at compounding your equity investment. That means working for you, the ordinary shareholder, not the bank manager, the preference shareholder, the loan stockholder or the minority interest.
The superior company will earn a superior return on book value for its shareholders year in, year out. In effect, these companies are defying the first law of capitalism; that excess returns are competed away to the cost of capital.
ROE starts with the surplus on trading earned for shareholders after deduction of all prior claims (interest, tax, preference dividends, minorities, etc.). This is then divided by the book value of equity on the balance sheet (after adding back any written-off or amortised goodwill or acquired intangible assets and deducting any pure accounting items such as a revaluation reserve).
It is usual to take the average of opening and closing equity, rather than the value at the year-end; hence return on average equity (ROAE). This is because events like a large acquisition late in the year would distort the picture by boosting equity fully whilst making only a small contribution to earnings. If earnings grow faster than the increase in equity, ROE will expand, and vice versa.
So, how do growth and ROE interact? Imagine two companies, Berkshire and Hathaway, both with sales of £100m. However, they differ in their earnings margins and returns on equity (ROE). Berkshire has an 8% earnings margin, yielding £8m in post-tax profit, while Hathaway enjoys a 10% earnings margin, resulting in £10m in net profit. Both operate in similar industries and possess comparable growth prospects, with equal market capitalisations of £100m.
If we focus solely on earnings growth prospects and the price-to-earnings ratio (P/E), Hathaway might seem like the better value due to its higher earnings margin. Hathaway's P/E is 10x, while Berkshire's is 12.5x. But there's more to consider.
The concept of return on equity comes into play. Assuming Berkshire's equity is valued at £40m and Hathaway's at £80m, their respective ROEs stand at 20% and 12.5%. This reveals that Berkshire effectively utilises its equity to generate more sales, compensating for its lower earnings margin. For each £1 of equity invested, Berkshire generates £2.50 in sales, compared to Hathaway's £1.25.
When both companies reinvest two-thirds of their earnings and pay out one-third as dividends, they reinvest at rates mirroring their historic ROEs. Over five years, Berkshire's earnings grow from £8m to £15m, while Hathaway's earnings increase from £10m to £14.9m. Berkshire's superior ROE allows it to catch up and surpass Hathaway's earnings within this timeframe.
The power of compounding further accentuates the impact of a higher ROE over time. After a decade, Berkshire's earnings could reach £28m, while Hathaway's might be at £22.3m. This translates to lower P/Es of 3.6x for Berkshire and 4.5x for Hathaway, indicating potentially stronger share price performance for Berkshire.
It immediately becomes apparent why Warren Buffett once said: “We like stocks that generate high returns on invested capital where there is a strong likelihood that it will continue to do so … it’s really the interaction of capital employed, the return on that capital and future capital generated versus the purchase price today”.
Understanding the interplay between growth and return on equity is crucial in evaluating a business's economic value. A higher ROE can compensate for lower earnings margins, leading to stronger growth and better value over time.
By focusing on businesses that consistently generate strong ROEs, investors can make more informed decisions about their investments. Ultimately, this knowledge empowers us to identify businesses with the potential to yield better returns and contribute to long-term wealth creation.
Keith Ashworth-Lord, is chief investment officer of Sanford DeLand. The views expressed above should not be taken as investment advice.