It is likely for an investor to earn a good return on their holdings in the long-term if the underlying business is earning a good return on its capital. For shareholders ROE is paramount as it isolates the returns that belong to the shareholders from the returns to the enterprise as a whole.
Buffett usually talks about financial ratios, the most important of which is ROE. Return on equity is net income divided by the book value of shareholders’ equity. ROE has to be deeply examined. An examination of ROE over an extended period of time should help an investor determine the performance of the underlying business that finally is reflected in stock returns.
Since ROE is computed from accounting data, it should be used it as a starting point for inferring stock returns, but numbers should not be followed blindly. Generally speaking, no one has to rely on financial ratios. It is fundamental to study growth in earnings per share over an extended period beyond examining the levels of ROE. Any financial ratio can be meaningless or lead to misleading inferences under certain circumstances.
Let´s for instance analyze IBM (IBM, Financial)’s 2004 financial data in 2005. It is discovered that the average ROE for the six years that ended in 2004 was 31.5 percent. At first that seems great. However EPS was in a bad shape. EPS was $4.25 in 1999 and remained about the same, except for an increase in 2004 to $4.93. On a compounded basis, the annual growth rate was only 2.5 percent. Why was this possible? By doing further research, it is found that the company purchased shares at market prices but issued them to employees below cost as compensation. For IBM, the net result was that shareholders’ equity did not grow because some of the earnings were effectively used for employee compensation and for repurchases.
It is paramount to ask the value of the company´s common shares if there is no assuredness about the computed ROE and growth in earnings.
ROE´s mate is Return on Assets or ROA. The goal with ROA is to obtain a measure of performance that is independent of financing. ROA presents performance of all the assets employed by the company, not just equity. Thus, the denominator is total assets and the numerator is earnings before interest expenses, adjusted for taxes.
A comparison of ROA to ROE shows the extent to which the company may be using implicit or explicit leverage. In a balance sheet, under the liabilities column, the items are non-interest bearing, so an examination of interest expense or the balance sheet analysis would not tell the extent of financial leverage.
It must be born in mind that knowing accounting is good in understanding the underlying profitability of the company. The analysis would also help assess the quality of management. If management quality is good, the financial statements are generally easier to understand.
ROA and ROE are not the most important financial ratios. There are others. Of course, the use of any of the financial ratios depends on the business model of the company and the aspect of the underlying performance one wants to better understand.
The main purpose of digging deeper into financial statements is to finally develop better forecasts of future earnings and better estimates of intrinsic value.
As regards accounting, Buffett encourages investors to develop a good knowledge of accounting.
Accounting numbers are based on a large number of estimates, and hence, they are not really hard numbers. Yet, academic research shows that long-short investing strategies can often be developed by using accounting knowledge.
Buffett writes, “Managers thinking about accounting issues should never forget one of Abraham Lincoln’s favorite riddles: ‘How many legs does a dog have if you call his tail a leg?’ The answer: ‘Four, because calling a tail a leg does not make it a leg.’
Most accounting numbers are reliable, but it is useful to remain vigilant. Here are some aspects of accounting that should be kept in mind:
1. Accountants make many assumptions. Every reported number is based on assumptions that are different across companies and on accounting rules that change over time.
2. Most accounting numbers are historical in nature. Most accounting valuations of property, plant, and equipment are made at their depreciated amounts. In the case of land, it is never depreciated.
3. Accountants may or may not use market prices for liquid assets. Companies can choose the accounting methods depending on the declared purpose and the amounts of stocks and bonds held as investments. Some assets and liabilities are marked to market while others are not.
4. Accountants are supposed to be conservative. But in many cases they are aggressive.
Return on investments in common stocks largely depend on the underlying return on the capital used in the business which can be measured by ROE and ROA.
If the returns are properly used, they bring about growth in earnings per share. Therefore, it is essential for every investor to use these financial ratios to examine how the business is performing.
Buffett usually talks about financial ratios, the most important of which is ROE. Return on equity is net income divided by the book value of shareholders’ equity. ROE has to be deeply examined. An examination of ROE over an extended period of time should help an investor determine the performance of the underlying business that finally is reflected in stock returns.
Since ROE is computed from accounting data, it should be used it as a starting point for inferring stock returns, but numbers should not be followed blindly. Generally speaking, no one has to rely on financial ratios. It is fundamental to study growth in earnings per share over an extended period beyond examining the levels of ROE. Any financial ratio can be meaningless or lead to misleading inferences under certain circumstances.
Let´s for instance analyze IBM (IBM, Financial)’s 2004 financial data in 2005. It is discovered that the average ROE for the six years that ended in 2004 was 31.5 percent. At first that seems great. However EPS was in a bad shape. EPS was $4.25 in 1999 and remained about the same, except for an increase in 2004 to $4.93. On a compounded basis, the annual growth rate was only 2.5 percent. Why was this possible? By doing further research, it is found that the company purchased shares at market prices but issued them to employees below cost as compensation. For IBM, the net result was that shareholders’ equity did not grow because some of the earnings were effectively used for employee compensation and for repurchases.
It is paramount to ask the value of the company´s common shares if there is no assuredness about the computed ROE and growth in earnings.
ROE´s mate is Return on Assets or ROA. The goal with ROA is to obtain a measure of performance that is independent of financing. ROA presents performance of all the assets employed by the company, not just equity. Thus, the denominator is total assets and the numerator is earnings before interest expenses, adjusted for taxes.
A comparison of ROA to ROE shows the extent to which the company may be using implicit or explicit leverage. In a balance sheet, under the liabilities column, the items are non-interest bearing, so an examination of interest expense or the balance sheet analysis would not tell the extent of financial leverage.
It must be born in mind that knowing accounting is good in understanding the underlying profitability of the company. The analysis would also help assess the quality of management. If management quality is good, the financial statements are generally easier to understand.
ROA and ROE are not the most important financial ratios. There are others. Of course, the use of any of the financial ratios depends on the business model of the company and the aspect of the underlying performance one wants to better understand.
The main purpose of digging deeper into financial statements is to finally develop better forecasts of future earnings and better estimates of intrinsic value.
As regards accounting, Buffett encourages investors to develop a good knowledge of accounting.
Accounting numbers are based on a large number of estimates, and hence, they are not really hard numbers. Yet, academic research shows that long-short investing strategies can often be developed by using accounting knowledge.
Buffett writes, “Managers thinking about accounting issues should never forget one of Abraham Lincoln’s favorite riddles: ‘How many legs does a dog have if you call his tail a leg?’ The answer: ‘Four, because calling a tail a leg does not make it a leg.’
Most accounting numbers are reliable, but it is useful to remain vigilant. Here are some aspects of accounting that should be kept in mind:
1. Accountants make many assumptions. Every reported number is based on assumptions that are different across companies and on accounting rules that change over time.
2. Most accounting numbers are historical in nature. Most accounting valuations of property, plant, and equipment are made at their depreciated amounts. In the case of land, it is never depreciated.
3. Accountants may or may not use market prices for liquid assets. Companies can choose the accounting methods depending on the declared purpose and the amounts of stocks and bonds held as investments. Some assets and liabilities are marked to market while others are not.
4. Accountants are supposed to be conservative. But in many cases they are aggressive.
Return on investments in common stocks largely depend on the underlying return on the capital used in the business which can be measured by ROE and ROA.
If the returns are properly used, they bring about growth in earnings per share. Therefore, it is essential for every investor to use these financial ratios to examine how the business is performing.
