The importance of SUSTAINABLY high ROE

One of the most important investment metrics that you need to grasp

Hi there!

So, last week I posted a hypothetical comparison of two different companies in order to illustrate some important investment concepts you need to understand.

If you have attempted the exercise, I am sure you will get a lot more out of it. So here it is again if you have not tried it yet:

Below are 2 potential investments.

Company A:

- Share price $10. (Not bad, almost single digit PE)

- Earns $1 per share in year 1

- Book value per share of $20, (ie only 0.5 times book value! cheap!)

- Pays out 100% of its earnings as a dividend every year, so dividend per share is $1 and the dividend yield is 10%! (Yum!)

- ROE is 5%

Company B:

- Share Price $22 (wah! 22x PE!)

- Earns $1 per share in year 1 (same as Co.A)

- Book value per share $4 (yikes! 5.5x book value!)

- Does not pay any dividends. Earnings are reinvested in the business.

- ROE is 25% (much higher than A, meaning it can make more money for every $ of capital)

ROE means Return on Equity. It is a measure of how much money can be made per dollar of capital invested. If a company makes $1 for every $10 of capital or equity it has, then the ROE is 10%.

Question:

• Which company would you buy and hold for 10 years? The one that pays you a 10% dividend yield every year for the next 10 years? Or the one that grows much faster but will not pay you any dividends?

• Why?

Even if you don't have a clue what I am talking about, just make a guess with a reasonable reason?

Assuming:

• The 2 companies retain their ROE at 5% and 25% respectively.

• They trade at the same PE Ratio respectively in 10 years' time.

• Your required rate of return is 8% (roughly what you can get from an index fund over the long term so we use that as a benchmark)

This is what you end up with:

Company A:

• Makes $1 out of the $20 worth of net assets it has on its balance sheet.

• You can think of this as someone investing say, $10m to build a factory that makes widgets, $5m to buy equipment, $5m for working capital and inventory. And that business makes $1m every year, which is paid out to shareholders. And it will keep doing it for the next 10 years.

• Mr A, who built the business, decides to sell the business to you, and you buy it for $10m, which is 50% cheaper than he paid to start it, and based on the $1m it earns every year, you get a 10% dividend yield. ($1m received every year, divided by your investment of $10m).

• You then get to sell the same company for $10m in 10 years' time, and get to keep all the dividends you had received.

• Good deal eh!

• If your required rate of return is 8%, and you discount all the future $1m dividends into the present (because future money is "worth less" than money now), your future stream of dividends and the sale price of $10m is actually worth $11.34m, so $10m is a decent investment if your required rate of return is 8% or less. Of course, if your required rate of return is higher, eg 15%, then those future cashflows are only worth $7.5m

What about Company B?

Company B:

• Is very good at making use of the resources at its disposal and is asset light

• Someone invested $4m to develop a design for a unique widget and get working capital. This company also makes $1m in the first year. But does not pay out any dividend. Instead, they retain all the money made every year, and uses it to grow the business.

• Mr B offers to sell you the business for $22m (which is equivalent to 22x PE or 5.5x the book value of the business). You might balk at it because he only invested $4m to create it, and now wants to sell it to you for $22m.

• Because there are so many growth opportunities available, the $1m profit from year 1 is reinvested and added to the net asset of the business, so that it becomes $5m at the start of Year 2. Again, they managed to make a 25% return on the equity of the business, producing $1.25m in profit for year 2. This goes on and on for the next 10 years.

• By year 10, the amount of retained assets in the business has grown to almost $30m. And at the same ROE, it generates about $7.45m in profits.

• In this company, there are no dividends collected, so the only way to get your money back is to sell the entire company in Year 10. If you can also sell it for 22x PE, then you will be able to sell it for about $164m, or about 7.5x what you had paid for it! Even if there is valuation contraction (eg the PE drops to 10x), you will still have a pretty hefty return. You can sell the company for $74.5m), or a 3.3x return.

What is the point of this whole exercise?

Of course, this is a very simplified exercise and I have made a lot of assumptions and not considered many factors (eg whether the company has high debt and is risky etc), or tax considerations. 

What I was trying to illustrate was the importance of looking for companies that know how to generate sustainably high returns from the capital given to them. That is what ROE is, Return On Equity. The key word here is SUSTAINABLE, meaning they can maintain those high rates of ROE. THESE are the types of companies that will end up being multi year compounders.

You may be thinking that is not possible, but there are actually many companies (not even high tech ones) that have maintained very high ROEs all these years. Look for free stock screening websites and look at the past 5-10 years' ROE for the company you are interested in.

Has the company you are considering been able to generate sustainably high ROEs?

Have fun hunting!

:)