Tomato, (on ROE)
>>Could you try to explain this to someone who has no accounting
background. Also, is there any relationship between ROE and the growth
rate? <<
Let me try to help here. This is up my ally.
First, to understand the importance of ROE it helps to conceptually think of a business as a sort of bank CD with an interest rate.
The higher the ROE, the higher the interest rate. Now let's apply that concept to 2 businesses and 2 scenarios.
Let's say company A earns 10% on equity and company B earns 20% on equity.
Let's say A has $10 dollars invested and B has $5 dollars invested in their respective companies (CDs).
Under these assumptions both will generate $1 dollar of interest (profit).
If both reinvest the entire dollar, A has $11 and B has $6 at the end of the year.
If they both generate the same ROE going forward, in year 2 A will generate $1.10 and B will generate $1.20.
You should see already how compound interest rates and business returns work similarly. B will leave A in the dust over the long haul if he can maintain that ROE.
Now let's try a second variation. Same assumptions except both A and B have an opportunity to grow their business by only 5% given current market conditions.
To grow sales/earnings etc.. 5% "A" will have to reinvest .50 of the dollar in earnings at 10% (ROE) to move sales/earnings etc... to $1.05. This leaves .50 for other purposes like share repurchases or dividends.
To grow sales/earnings etc.. 5% "B" will have to reinvest .25 of the dollar in earnings at 20% (ROE) to move sales/earnings etc... to $1.05. This leaves .75 for other purposes like share repurchases or dividends.
Again you should see the benefits of the higher ROE.
The key here as Mike stated is that companies can manipulate ROE with debt. Also, a high ROE in the past is not a guarantee of a high ROE in the future.
So to use this concept effectively it becomes necessary to try to identify companies with a business position, cost structure, size, brand quality, customer loyalty, or business model that gives it a "sustainable" edge. These birds are few and far between and in this market very very expensive.
In my own investing I pay less attention to the quarterly swings in earnings than most investors do. I pay more attention to the company's business position. I try to estimate the normalized or average return the business might be able to generate over the next 5 or 10 years. If I can't do that (and that's very very often) I pass.
I hope this helped a little in understanding the greater value of high ROE.
Wayne
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