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Politics : Ask Michael Burke -- Ignore unavailable to you. Want to Upgrade?

To: Tomato who wrote (54253)	4/1/1999 6:30:00 PM
From: Knighty Tin	Read Replies (1) \| Respond to of 132070

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. MB

To: Tomato who wrote (54253)	4/1/1999 8:04:00 PM
From: Freedom Fighter	Read Replies (1) \| Respond to of 132070

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