Before we begin on this article, we would like to share the glossary:
- Earnings Per Share (EPS) = net profits attributable to owners of the company / number of outstanding shares
- Return on Equity (ROE) = net profit attributable to owners of the company / shareholders’ equity
- Return on Asset (ROA) = net profit attributable to owners of the company / total assets
In chapter 3 of ‘The Warren Buffett Way‘, author Robert G. Hagstrom stated that…
Customarily, analysts measure annual company performance by looking at earnings per share. Did they increase over last year? Are they high enough to brag about? Buffett considers earnings per share a smokescreen. Since most companies retain a portion of their previous year’s earnings as a way of increasing their equity base, he sees no reason to get excited about record earnings per share. There is nothing spectacular about a company that increases earnings per share by 10 percent, if, at the same time, it is growing its equity base by 10 percent.
To put it simply, a company’s earnings per share should grow year after year because of their enlarged equity base after each year’s profits is added to their capital base — ceteris paribus. This is nothing to be excited.
To measure a company’s true economic performance accurately, Return on Equity (ROE %) is another metric you may want to consider. If this metric is improving, this means that the company is more efficient in generating money for every dollar of equity it has — as compared to merely looking at the EPS growth which could be derived from the equity’s growth.
To have a higher ROE, the net profit must grow proportionally higher than the company’s equity.
A superior business should achieve good ROE while employing little or no debt. Debt has the ability to push up the ROE figure when a company adds more debt, its liabilities increase, so does its total assets. With an increased total assets amount, the business theoretically should make more profits. However, the equity remains the same. Therefore, the use of debt pushes up the figure of ROE.
If a company is highly leveraged, you may want to look at its ROA as a check whether the debt is efficiently utilized. The check can be done by comparing its ROA with its effective borrowing rate.
Example – Company A
What if company A decides to take up a debt of $30 million to generate an additional of $3 million of net profit after tax?
With an additional of $3m net profit through the use of leverage, it pushes up company A’s ROE to 33% while its ROA deteriorated to 20.6%.
All being equal, a company with high ROE with low debt is superior when compared with another company with the same ROE but highly leveraged.
The distinction comes when you find out what is the source of the high ROE figure.
In any case, it is recommended to avoid high leveraged companies unless…
- the business moat is strong
- you understand the business and it is your circle of competence
- the company has strong cash flow generating abilities
- competent management with a good track record
It is time to for you to search for companies with high ROE without debt, it might be an indication of their pricing power and moat which allows them to be more profitable than their peers.
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