10-year

10-Year Anniversary Promotion (20% off)

Join GuruFocus Premium Membership Now for Only $279/Year

Once a decade discount

Save up to $500 on Global Membership.

Don't Miss It !

Free 7-day Trial
All Articles and Columns »

Warren Buffett's Preferred Financial Ratio

October 04, 2010 | About:
Josh Zachariah

Josh Zachariah

38 followers
One of Warren Buffett’s preferred financial ratios is the return on equity. He acknowledges this give the clearest indication of a company’s profitability and potential for growth. Unlike year on year net earnings growth, this measure is much more difficult to be manipulated barring high leverage which can be easily discerned from the balance sheet. Many of the companies he holds shares in exhibit high returns on equity as the following chart shows. The article below it gives a great summary of the metric and how companies with high returns on equity perform.

Berkshire Hathaway's Top 10 Holdings -Return on Equity

Coke 30.55%

Wells Fargo 9.96%

Kraft 9.78%

American Express 23.3%

Johnson and Johnson 27.3%

Wal-Mart 23.53%

Proctor and Gamble 17.62%

Conoco Phillips 15.22%

Wesco 2.67%

Average For Top 10 -16.9%

Picking Stocks the Warren Buffett Way-Understanding ROE


Disclosure: Holding shares in Berkshire Hathaway

Josh Zachariah

About the author:

Josh Zachariah
I credit my father and Warren Buffett for molding me into the investor I am today.

Rating: 4.2/5 (9 votes)

Comments

jhodges72
Jhodges72 - 4 years ago
Return on equity is defined as net income / shareholder equity. There's a couple adjustments I believe Buffett applies that he doesn't explain. It's just a gut feeling I have, and regardless, it makes sense for me and how I calculate the ROE.

In the past, buffett has stated that GAAP net income is flawed. Therefore, adjustments to non-operating income/expenses, impairment charges that require to use of cash, and other one time charges should be disincluded. Why? Because we're trying to gauge the on going steady operations of the business. If your primary business is to sell cans of soda and this year you sold a piece of real estate that you've never done before and never plan on doing again with any matter of consistency is a piece of earnings that should be taken out of the picture.

After making thise adjustments (the art to value investing) the same types of adjustments should be applied to balance sheet. Book value should never be taken as an ending point, but rather a starting point. Proper adjustments to find the true economic value of tangible assets need to be applied. A lot of work is needed. Unless you're an expert at valuing the intangibles of the business, they should be stricken from your calculation.

In the end, you're left with a solid picture based on the "ongoing operations" of the business backed by a reliable "tangible" value. It's a bit more complex than simply taking net income / shareholder equity and the resulting information will give you a much clearer picture of the truth.
jhodges72
Jhodges72 - 4 years ago
By the way, I meant to give your article 4 stars rather than 3. I'm typing from a phone and my finger slipped. Also the reason for all my spelling errors above. I appologize.
batbeer2
Batbeer2 premium member - 4 years ago
>> the same types of adjustments should be applied to balance sheet.

Hmmmm.. an example ?

In an asset based valuation, I would agree. For calculating ROE, not. ROE is relevant because you want to take the cost of those assets into account. If you require 100 dollars to earn 1, that is not a very good business. If you need just 4 dollars to earn a dollar per year (ROE = 25%) that is not bad at all. For one, you can grow the latter 100% in (less than) four years without taking on debt.

The point is, I think book value as reported is a very accurate estimate of the cost of assets. I cannot remember adjusting book value to find ROA or ROE. For an asset based valuation, that is another matter. Often, the cost of an asset is not equal to its value.

In short, I think you need to adjust GAAP earnings to find ROE and ROA but not the book value.

@ Josh

Thanks for the article.
jhodges72
Jhodges72 - 4 years ago
batbeer2,

Understand your point but you won't find the "costs" of producing intangibles listed under "intangibles" on the balance sheets therefore it's an irrelevant point in respect to what I discussed.
jhodges72
Jhodges72 - 4 years ago
In addition, my point by making thos adjustments is ti find the true sustainable costs and return of the business, not annual anomalies. If year 1, 2, & 3 XYZ priduced an ROE of 8%, 9%, 8% and then in year 4 the pps fluctuated low and the standard ROE calculation produced an 19% ROE, some may get overly excited and think an opportunity exists that actually doesn't because in year 4, the company sold off an asset that had nothing to do with the steady course of their business and increased the book value of the company. That's a false representation of their normal sustainable ability to operate.
batbeer2
Batbeer2 premium member - 4 years ago
Hi Jhodges,

you won't find the "costs" of producing intangibles listed under "intangibles"

Correct me if I'm wrong, but IMO that is exactly what you will find under "intangibles" on the balance sheet. If that number does not represent the cost of the intangibles, then what does it represent ?

Yes, KO has assets that you won't find on the balance sheet. PEP has similar assets, but they are on the sheet for the simple reason that PEP paid cash to acquire those assets. KO did not.

Is it therefore not fair to say that KO, historically, has been the company with the superior ROE ?
jhodges72
Jhodges72 - 4 years ago
Continuing from above, by doing it this way, we've eliminated the risk of that ROE falling the following year to, say, 2% because the company decided to take the year 4 extra cash balance and replace that asset in year 5. So, in year 4 you purchased based on a 19% ROE and in year 5 they replace the asset they disposed of previously. When they do so, what are you going to think about year 5's ROE of 2%?

Making the adjustments the way i've described eliminates this problem.
batbeer2
Batbeer2 premium member - 4 years ago
and then in year 4 the pps fluctuated low and the standard ROE calculation produced an 19% ROE, some may get overly excited and think an opportunity exists that actually doesn't

Yes
jhodges72
Jhodges72 - 4 years ago
I think you're talking about goodwill which is the amount in excess a company paid for an asset above the value of that asset. In theory, it's an intangible item but is most often listed as goodwill.
jhodges72
Jhodges72 - 4 years ago
To sum it up in its simplest form, one needs to go through the financial statement with a fine tooth comb in order to decide what is and isn't. Simply taking the GAAP accepted book value is going to produce what's acceptible for GAAP purposes but not for true economic value purposes.
batalha
Batalha - 4 years ago
I disagree, I think that Equity or Capital Employed can be adjusted for an adjusted ROE or ROIC calculation. Some companies have cash far in excess of operations needs, true negative working capital or Off Balance liabilities that must be taken into account. I seldom do these adjustments but think they are totally feasible. My two cents.

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK