The investment world is -- whether we like or not -- fixated on the earnings numbers of a business. In the short run, stock prices are very sensitive to a company's earning achievements. Exceed the general expectation, and stock prices rocket. Disappoint the analysts, and stock prices plummet.
A better picture
While profit matters, understanding why and how it matters is a central concept in long-term value creation. This is where return on equity comes into play. Simply defined, ROE is calculated by dividing net income by average shareholders equity.
In a fundamental sense, businesses with sustained high returns on equity are usually followed by appreciating stock prices. The following example will illustrate why high rates of return on equity, in my opinion, create more value than just simply growing earnings.
Why he became the world's richest man
Theoretically, in the long run, a stock's rate of return should equal its return on equity. Let's consider Microsoft
When Microsoft was just starting off, it had lots of space in the software market to deploy its capital. So, for example, if Microsoft was generating a ROE of 40%, it was able to continue investing that excess capital and generate a similar rate of return. So Microsoft could invest a million dollars in its operations and earn $400,000. Microsoft could then take that $1.4 million and earn 40% on it, and so on. Imagine being able to do this with billions of dollars -- the results are staggering. This is exactly what Microsoft and others like Dell
It is no surprise, then, that Microsoft's (and Dell's) stock rocketed for many years after their IPOs, and that guys like Bill Gates and Michael Dell got so fantastically rich. The company was creating $0.40 from each dollar at will and then 40% on that additional capital. Anytime you can do this for a sustained amount of time, the intrinsic value of a business mushrooms, and eventually, so will the stock price -- thus the magic of compounding.
What went wrong?
Microsoft currently generates returns on equity of over 40%, so how come it isn't making new investors fabulously wealthy? The problem is that Microsoft is so huge and has so much cash, that it is now able to generate those returns only on the capital needed to run the business. It can no longer take the excess $400,000 and earn 40% on it. This is why it paid that huge dividend a few years back. It made more sense pay out some of that excess capital to shareholders than to reinvest back in the business.
Anytime you locate a company that offers the talent and ability to redeploy its existing and excess capital at above-market rates of return, you need to examine the opportunity very closely. An ability to earn excess returns on equity signals that the company offers certain competitive advantages not easily reproduced by its competitors. This explains why Warren Buffett bet a large chunk of Berkshire Hathaway's
Profits and earnings growth are vital. But it's what a business can do with those profits and for how long that sets great businesses apart from good ones. Careful observation and understanding of the return on equity is one way of truly analyzing the profitability of a business. In the next article, I will discuss which actions affect the return on equity.
Fool contributor Sham Gad is the managing partner of the Gad Partners Fund, a value-centric investment partnership. He has a stake in Berkshire Hathaway. The Fool owns shares of Berkshire and owns a value-centric disclosure policy.