Some caveats with using high ROE screens to search for Warren Buffett-style investments
- Debt-Loaded High ROEs
ROE is calculated as the product of net income margin, asset turnover and leverage. High leverage will artificially boost ROE. High ROE stocks with huge amounts of leverage need to be viewed with caution, as leverage is masking an inferior operating efficiency and competitive position.
- Cash-Rich High-Quality Firms
Firms with a lot of cash on their balance sheet will results in low ROE, since the interest earned on cash pales in comparison with the operating margin of the firm's core business. One way to remedy is to calculate ROE on an ex-cash basis.
- One-Offs Obscure True Profitability of Firms
The key to ROE is the net income figure, which itself is full of distortions by one-offs and accounting rules. Non-cash write-downs and charges may hit the P&L of a firm and result in low ROE for that year. Similarly, firms may boost ROE in any single year through accounting sleight of hand or divestment of assets.
- Temporary High ROEs for Commodity-Like Business
Firms in commodity-like business may show up on the high ROE screen because of industry consolidation or mergers and acquisition activities. However, the effects on ROE are likely to be temporary as the law of zero economic profits for commodity-like markets comes into play.
Recast the financials of the firm you are looking at or "start with the As" as Buffett suggests.
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