This year marks the 50th anniversary of Warren Buffett's purchase of Berkshire Hathaway. The company's results have been astounding during this one generation of ownership: $1 invested in Berkshire Hathaway stock in 1965 is worth over $1.1 million today. So it would seem that Buffett is doing something right.
If you review Buffett's letters to shareholders in the company's annual reports, you will find they reveal the one measure he uses to determine whether he believes he is doing a good job as CEO. The first sentence of every shareholder letter begins with, "Our return on equity for last year was..."
Return on Equity (ROE) - sometimes referred to as Return on Invested Capital - is defined as the amount of net income returned as a percentage of shareholders equity. It measures a company's profitability by revealing how much profit the company is generating with the money its shareholders have invested. ROE is probably the clearest measure of how well management is running the business because it incorporates three important areas:
- Net margins
- Efficiency in utilization of assets
- Proper use of leverage
Net margins: The size and quality of a company’s gross and net margins are the two most important things on the company’s income statement. When many people think of a successful year, they think about sales growth - which is a mistake. Sales growth without commensurate margin growth does not create value in a company.
Asset utilization: Companies with high ROE use the assets at their disposal in an efficient way. They are very discerning about their working capital turnover and their utilization rates of their fixed assets.
Leverage: Lastly, companies with high ROE know the proper blend of equity and debt to leverage their assets in ways to maximize returns but not over-leverage the business.
This combination of operating performance, efficient utilization of resources, and proper leverage is what drives ROE.
We also like this measure because it implies that you are looking at the business as an investor, instead of as the place where you hang your hat. Getting a return on capital is important for money you give to a broker to invest for you, so why not demand a return on the capital you have under your control and discretion at your company? After all, if you are not getting a return commensurate with the risk you are assuming as the owner, perhaps the capital would be better utilized elsewhere.
Ultimately, the value of any business increases when its return on invested capital exceeds the cost of capital. Considering that most private company owners have a concentration of their wealth in the stock of their companies, it is critical to view the business as an asset that should be continually increasing in value. Driving your ROE is the principal way to do just that.
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