11 minutes

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.

In today’s article, we will learn the formula for return on equity, how it works, where we can find the numbers for our calculations. Also, we will get some insights from great investors who use this formula to help them find great businesses.

Today’s article will be the first in a series of articles to help us gather information to learn how to value financial institutions like banks, investment houses, and insurance companies. These can be a little more complicated, so we will take bit sized pieces to learn to steps to value these businesses.

**What is Return on Equity?**

According to Investopedia.

“Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders has invested.”

Pretty easy, right?

So the formula takes the net income or profit of a company and measures it against the money that we shareholders invest in their company.

I think that illustrates why this formula might be important in helping us determine whether management is doing a good job managing our invested capital.

Return on equity can be a critical weapon in our arsenal, but it is important to understand what it is and how to use it. The formula encompasses the three pillars of management; profitability, asset management, and financial leverage. Or said another way, profits, assets, and debt.

By seeing how well a management team balances these pillars gives us a great idea of whether the team can get the job done. After all, it is our money that we have invested in this company.

A final thought, Return on Equity is a quick way to gauge whether the company is an asset creator or a cash cow. With the ROE, an investor can quickly see how much cash comes from existing assets.

Let’s say the ROE is 57% like Buffett’s Berkshire Hathaway (BRK.B) then that means for every dollar invested he generates 57 cents of assets. Now that is what we are talking about!

On the flip side of that equation, a low return on equity means that the company is not generating much in the way of assets for our invested capital. If for example, the number is 8%, then the company is creating 8 cents of assets per one dollar of investments.

Ideally, we are looking for a return on equity of the 15% to 20% range or higher. Keep in mind that high growth companies are going to have ridiculously high numbers.

**Return on Equity Formula**

Now for the formula:

**Return on Equity (ROE) = Net Income / Book Value of Equity **

To break this down a little bit, we can look at each variable and determine what it equates to so we can track down the numbers.

**Net Income =**Net income represents the amount of money remaining, after all, operating expenses, interest, taxes and preferred stock dividends (but not common stock dividends) have been deducted from a company’s total revenue. This value can be found on the bottom line of the income statement. Thus the reference to the bottom line when referring to revenue.**Book Value of Equity =**Often referred to as shareholder equity. It is simply the difference between total assets and total liabilities. Shareholder equity indicates the assets that a company has created. This number is on the balance sheet.

There are three ways that return on equity can be calculated.

- Using the annual numbers from the previous years 10-k
- Using the TTM (Trailing Twelve Month) numbers, which are calculated using annual reports as well as quarterly reports.
- Annualizing the numbers using the latest quarter’s results and multiplying them by four

I like to use either the annual numbers or the TTM as I feel it gives me the best idea of how the company is doing because I am using actual numbers.

Ok, let’s take a look at some examples of the return on equity.

**Berkshire Hathaway Return on Equity**

So, let’s take a look at the master’s return on equity, shall we?

What I will do with this first example is walk you through how I am gathering the information from the annual or quarterly reports.

All numbers unless otherwise noted will be in the millions.

**Net income**

Berkshire Hathaway 2016 Consolidated Statement of Earnings

Net Income = $24,074

As you can see from the report, the expenses including taxes and interest expenses are deducted from the revenue to arrive at net income.

**Book Value of Equity or Shareholder Equity**

Berkshire Hathaway 2016 Balance Sheet

Total Shareholder’s Equity equals $286,359, but we are going to make an adjustment to this number because there is a line item that does not pertain to our formula.

We are going to subtract the noncontrolling interests from the Total shareholder’s equity. The reason for this is because the noncontrolling interests are considered a minority interest and therefore subtracted from total shareholder equity. In accounting terms, this refers to equity ownership in a subsidiary not controlled by the parent company.

In other words, there is a part ownership of a business that Berkshire does not control and this would require the reduction of the total shareholder’s equity.

So to arrive at our total shareholder’s equity for our equation, we would subtract the noncontrolling interest and arrive at our number.

Total shareholder’s equity = $283,001

So putting it all together in our formula we would get this:

Return on equity = Net Income / Shareholder’s Equity

ROE = $24,074 / $283,001

**ROE = 8.50%**

So, that was surprising. I expected a little better result. Remember that we are looking for anything in the 15% to 20%, or higher.

A note about doing this with real companies.

- When we are looking deeper into the numbers with regards to the financial statements, unfortunately, not everything is going to line up neatly. Every company has their way of recording their information and some companies include items and others will include it in the notes. They all have to fall accounting rules, but the way they will lay them out in the financials can be different.
- The formulas that we have been working with are based on accounting rules, and I have several accounting books that I use to help me keep everything straight.
- If you ever have questions about how I am treating the numbers and how I am gathering them, reach out to me and let me know so I can help answer your questions. I am here to help.

Let’s take a look at Berkshire from the TTM point of view to compare to the annual report.

So first we will gather all the net income data for the TTM.

Quarter 1 March 2017

Net Income = $4,060

Annual 2016

Net Income = $24,074

Net Income for Nine months of 2016 = $17,788

Quarter 3 September 2016

Net Income = $7,198

Quarter 2 2016

Net Income = $5,001

So to calculate the TTM for Net Income, we would just use this formula:

TTM = Quarter 2 + Quarter 3 + (Annual – 9 months) + Quarter 1

TTM = 5001 + 7198 + (24074 – 17788) + 4060

Net Income TTM = $22,545

Now that we have the Net Income calculated we are going to do the same thing for the shareholder’s equity.

Quarter 2

2^{nd} quarter 2016 Shareholder equity = $264,025

3^{rd} quarter Shareholder equity = $269, 284

Annual Shareholder equity 2016 = $283,001

First quarter Shareholder equity 2017 = $292,851

Putting all these numbers together we get.

2^{nd} quarter + 3^{rd} quarter + Annual + 1^{st} qaurter

264,025 + 269,284 + 283,001 + 292,851 / 4

TTM Shareholder equity = $277,290

We do it this way to get the average Shareholder equity as it isn’t a cumulative number during the year. Remember that a balance sheet is a snapshot of one in the life of the business, unlike the cash flow statement or income statements which are cumulative documents.

Now that we have our numbers let’s plug them into our formula to get our TTM return on equity for Berkshire Hathaway.

ROE = TTM Net Income / TTM Average Shareholder equity

ROE = $22,545 / $277,290

TTM ROE = 8.13%

Not much different from out annual return on equity that we calculated earlier.

The reason we go through the process of calculating this formula for the TTM is to get the most updated numbers. When we use the freshest information, it gives us the opportunity to make our decisions based on the most current information possible.

You can find these numbers available on most financial websites such as gurufocus.com and they are a great resource.

However, I like to do them myself so that I can see the data with my eyes. It also helps me reinforce what I am seeing and where the numbers come from.

With the return on equity formula, it is best to look at an average of multiple years so you can see any trends in the business. You can do five to ten years, which would be best.

For our purposes today let’s look at five years.

- TTM 8.13%
- 2016 8.50%
- 2015 9.72%
- 2014 8.60%
- 2013 9.51%

The average return on equity would be: 8.89%

So, as you can see it is pretty consistent through the last five years, and there have been no big spikes or downturns, which makes them pretty well run. Who am I kidding, it is extremely well run.

The best way to use this information is to compare them to other businesses in their same sector. Since Berkshire is considered an insurance business, we should make a quick comparison to some insurance businesses to see how their numbers stack up to their competitors.

Insurance Companies | TTM | 2016 | 2015 | 2014 | 2013 | Average |

Berkshire Hathaway | 8.13 | 8.5 | 9.72 | 8.6 | 9.51 | 8.89 |

Allstate | 10.67 | 8.68 | 9.71 | 12.54 | 10.76 | 10.47 |

AIG | 0.62 | -1.02 | 2.23 | 7.26 | 9.15 | 3.65 |

Met Life | -0.92 | 1.03 | 7.36 | 9.26 | 5.15 | 4.38 |

Allianz SE | 9.99 | 10.68 | 11.23 | 11.57 | 10.5 | 10.79 |

As you can see from above, Berkshire does pretty well compare to some of its other competitors. Berkshire is a little different than the others because it is not solely an insurance carrier.

It is an interesting exercise to see how they stack up against each other.

Next, I would like to take a look at the return on equity of a bank, so we can see how that would work.

Let’s take a look at Wells Fargo (WFC), who until recently was the largest bank in the US by market cap; recently replaced by JP Morgan.

To do this analysis, I will use the annual report for 2016 and then we can look at a five-year range to see any possible trends.

**Wells Fargo Net Income 2016 = $21,938**

**Wells Fargo Shareholder Equity 2016 = $199,561**

Remember to subtract the noncontrolling interests from the total equity.

So, plugging the numbers into the formula.

ROE = Net Income / Shareholder’s Equity

Wells Fargo ROE = $21,938 / $199,561

**Wells Fargo ROE = 10.99%**

Now, let’s take a look at the five-year numbers so we can see if any trends are happening, or, if they are pretty consistent over the years.

- 2016 10.99%
- 2015 11.38%
- 2014 12.31%
- 2013 12.75%
- 2012 13.16%

The average for those five years being 12.12%, which is pretty good and very consistent. There are no large spikes up or down, but there is a trend down for the last five years. Granted it isn’t a huge drop, but it is something to keep an eye on in the future.

**Final Thoughts**

Return on equity is a great way to determine whether a company is an asset creator or a cash consumer. By relating the income to the shareholder’s equity, an investor can quickly see how much cash comes from existing assets.

Remember for if the return on equity is 20%, then the 20 cents of assets are created for every dollar originally invested.

A company that creates a lot of shareholder equity is a great investment because the original investors will be repaid with the income from the business operations.

Businesses that create high returns compared to their shareholder equity pay their shareholders fabulously and create substantial assets for every dollar invested.

Additionally, these businesses are typically self-funding and require no additional debt or equity investments.

A word of caution with this formula, if a company has a negative value for their book value or shareholder’s equity. When this occurs, the return on equity becomes a meaningless number, and you may have to look to others, such as return on invested capital.

Another factor to keep in mind, as with earnings per share, if the company has a negative number for Net income, then the formula is worthless.

Two other factors to consider when using this formula.

**Buybacks –**Stock Buybacks can also have a drastic effect on return on equity. Companies will regularly engage in stock buybacks for some different reasons. Sometimes, they will buy the stock back from the market just so that they can affect financial ratios such as return on equity. When a company buys a large number of shares from the market, they are going to reduce the shareholder’s equity significantly. When the company does this, they are also going to improve the return on equity ratio. Nothing fundamental change with the way that the company was doing business, but the return on equity jumped significantly. This is a major reason that financial ratios like return on equity have to be taken with a grain of salt when valuing a company.**Debt –**Another big problem with return on equity is that it does not take into consideration the amount of debt of a company. It only takes into consideration the net income and the shareholders equity. Therefore, a company could have massive amounts of excessive debt and still look like it is handling things well according to the return on equity calculation. Even though it might show a good ratio, it could be close to crumbling because it has more debt than it can handle. A quick way to determine this is to look at the company’s debt to equity ratio, and if it is above an acceptable ratio, it might be worth digging in more to see what is going on. More on this in a future article.

As you can see, there are some great things about this formula to like. It is incredibly easy to calculate and to find the data to fill in for the formula.

But, as with most formulas, you have to keep in mind what you are looking at and use it as a tool to compare different companies in the same sector so you can put it in context.

Additionally, you must never buy based on just one calculation. This formula is a tool to help us determine the financial strength of a company and to help guide us on the path to making a decision.

I need to thank Professor Damodaran once again for providing some excellent resources to help me understand and relate this information to you. You can check out his amazing work here. And take a moment to check out his website that has oodles of information in regards to this subject and more.

I would like to leave with the words from the master, Warren Buffett.

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

As always I want to thank you for taking the time to read this article. I hope you find it informative and of benefit to you.

Until next week.

Peace be with you,

Dave