Return on Equity: Quick and Easy Way to Find Asset Creators

10 minutes

return on equity

In his 1978 Berkshire Hathaway Letter to Shareholders, Warren Buffett stated.

“We believe a more appropriate measure of managerial economic performance to be return on equity capital.”

Measuring the performance of management of a business is a tricky proposition as there are no direct ways to measure it. We have the overall performance of the business, of course. Additionally, we can look to return on invested capital, growth in sales or earnings, or overall business health.

With a return on equity, we have a metric that can help us measure a management’s ability to generate profits from every dollar of shareholder’s equity. After all, creating wealth from the money we invest in a company is what we are all after. We want great businesses that compound our money to generate greater returns.

This formula is great for comparing businesses in related fields, i.e. retail, tech, oil, biotech, etc. One word of caution, this formula is not perfect. There are problems with it, and we need to be aware of those when we are using these numbers to value a company.

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Owner Earnings: One of Warren Buffet’s Favorite Formulas

10 minutes

owner earnings

Earnings season is upon us, as Wall Street chooses which companies to reward for a good quarter or punish for a bad quarter. Wall Streets obsession with earnings happens every quarter, the give and tug of who is rising versus the fallen. As value investors we don’t necessarily play this game, we are much more interested in the long-term outlook, as opposed to the short-term focus of earnings season. Warren Buffett eschews this mania, and instead, he focuses on what he calls “owners earnings.” These earnings to him are a better representation of the true earnings of a company.

This short-term focus that Wall Street has can cause a stock to rise or fall quite quickly, sometimes in the same day. As the bears and bulls of each side of the trade rush in and out to try to get a better position. This volatility can be maddening, and certainly, test the will of many people.

Buffett rises above this madness and instead chooses to hold a long-term approach that focuses more on the fundamentals of the business as opposed to the short-term earnings of one single quarter. These earnings that everyone places so much focus on can, and have been manipulated before, sometimes to great effect.

Many investors have been blindsided by this manipulation and have lost a ton of money because of the greed and deceitfulness of others. One way to avoid this is to do your research, and another is to adopt a long-term view that focuses on the fundamentals of the business and to see that they are doing the right things to grow the business.

What are Owners Earnings?

In the 1986 Berkshire Annual Shareholder Letter Buffett outlined his thoughts on owners earnings.

“If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c). However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)” 

Hubba, what? That was a mouthful, wasn’t it? Ok, let’s break this down a little bit. I liken it to eating a pizza, you can’t eat it all at once, as much as you would like, but eating it one piece at a time –

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