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Understanding Warren Buffett's Preference for ROE

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Nov 08, 2011
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It is widely known that the greatest investments are made in businesses with high ROE, especially on a long-term bias.

ROE is one of the most important factors that Warren Buffett looks at when deciding whether to make a deal or not.

Why is it so important?

Let's say you own Company A. It has $15 million in assets and $9 million in liabilities, with shareholders' equity of $6 million. If Company A receives after-tax earnings for $2,000,000, the ROE should be 33%.

What happens if instead of owning Company A, you own Company B? Company B also has $15 million in assets and $9 million in liabilities. The difference is that instead of making $2,000,000 on equity, it only makes $500,000. The ROE will be much lower; nearly 8%.

Undoubtedly, Company A is better than Company B. It is more profitable, even though both have the same structure, and both are very well managed.

The picture is much clearer with Company A. The ROE is significantly higher. Now what would happen if you are given the choice to receive a $2,000,000 dividend from Company A? Would you accept it and thus pay taxes or would you keep the holding and see how earnings increase with the 33% rate of return? The second choice is more seductive.

But if you were the owner of Company B, would you keep the holding with an 8% of ROE or withdraw the $500,000 dividend? You understand why ROE is paramount.

Let's pretend you don't own any of the two companies, but are in the market and you are willing to purchase one of them. You will probably consider each company's situation and see if the owners are willing to sell. Well in this case, it's necessary to consider what Buffett believes about rates of return: They all compete with rates of return on government bonds. It is evident that the stock market goes up when interest rates go down and vice versa. A ROE of 12% on stock is more interesting than a government bond offering a 5%. But, if the interest rate goes up and the government bond ends up offering you a 12% ROE? Isn’t it appealing?

Of course, the owners of Company A and B will go deep into this situation and see if it is convenient.

Company A earnings will amount to $2 million per year; so $25 million in government bonds will be necessary to reach the former amount in interest. Company A's owner will sell the company at $25 million. If you buy it, you will be paying 12.5 times Company A's current earnings of $2 million. Furthermore, you can only expect an 8% return in the first year.

Company B earnings amount to $500,000 per year. Then, it would take $6.25 million to generate $500,000 in interest. You will have to pay $6.25 million to have it and thus be paying 12.5 times the company's current earnings of $500,000. Just like in Company A, you can only expect an 8% return in the first year of ownership.

It seems there is now a different setting. However, bear in mind that for high rates of return to exist you have to let compounding work. You should not be interested in the amount of earnings in one year. You must have a long-term planning.

Now, if you calculate how the equity base will change from now to 10 years based on a 33% ROE and on an 8%, you will notice that Company A has more growing perspectives than Company B.

This is a hypothesis and you think that this calculation will never come true. To make it more real, I'll take one of his best buys: Coca-Cola (KO, Financial).

It is widely known that Coca-Cola has shown a 30% ROE since 1988. Warren knows it very well, because in 1994 he bought a large position therein.

This article aimed at showing you why ROE is important when deciding to invest in business. This is part of Warren's foundation for success. It helps earnings to increase and makes businesses much more interesting. I've definitely stoodd by it.
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