Tomato, Return on Equity is straightforward. It is the net income the company earns divided by the net equity invested in the firm. A high ROE is a good idea, everything else being equal, but it is just one indicator that can be greatly manipulated by slick management. The most common way to manipulate the ROE figure is with debt. If a co. has $1 billion in equity and earns $200 million with that investment, it has a 20% ROE. But, if they borrow another billion, pay 6% for it, and make another $200 million, less the $60 million interest paid, they are earning $340 million on the billion in equity, or 34% ROE.
That much is a true number. But, which is riskier, a company with no debt or one with a 50% debt to equity ratio? As long as things go well, the leverage helps you. But let's say you have a tough year and only earn $100 million instead of the $400 million from the good year. Now, you subtract that $60 million in interest and you only have a 4% ROE and your stock tanks. Or, what if rates go up and you are suddenly paying $100 million in interest? This impacts ROE. That is why many some investors look at Return on Assets, which would include the debt load. However, neither measure tells you much about the future.
ROE is a calculation based upon net income while earnings per share are based upon one share's portion of that income. Obviously, the higher ROE, again, adjusted for risk, the higher earnings per share and the higher the pe ratio is likely to be.
One problem Buffett and others have is that they are looking at what the co. made before. They don't know what they'll make in the future. Coke's ROE will not be anywhere near its recent levels this year, and the stock is getting whacked. That high pe ratio that Warren was willing to pay for a high ROE is shrinking as the ROE shrinks and it is now pounding his performance again this year. A very risky way to invest, IMHO.
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