FOOL SCHOOL
Valuation: Uses of Return On Equity

February 17, 2003

Return on equity (ROE) is favoured by Warren Buffett, arguably the greatest investor of all time. In her excellent book Buffettology, Mary Buffett, ex daughter-in-law of Warren, goes into great detail about the valuation techniques that Buffett uses. Somewhat contrary to his apparent dependence on discounted cash flow highlighted by Robert Hagstrom in his book The Warren Buffett Way, Mary Buffett indicates that he concentrates largely on a company's ROE when determining its value.

However (there's always a however) this sort of valuation is only applicable for companies that have a high degree of predictability of earnings. Looking 10 years out for start-up companies, or high technology concerns that have rapidly depreciating products that are obsolete in a matter of months, you'll find it is almost impossible to predict what sort of a returns they will be earning. That's not to say that you should never be invested in those types of companies, it's just that using a 10-year ROE model is probably not the most suitable. Likewise, companies that are currently going through rapid periods of growth should not be valued as if that rate of growth will be maintained for a year, let alone 10 years.

Clive's Canny Carvings (CCC)

CCC is a newly floated company, starting with owner's equity, or shareholders' funds, of £1,000. From that investment the company made an after tax profit of £200, giving CCC a return on equity of 20% (£200/£1,000 = 20%). Of that £200 attributable to shareholders, CCC decides to pay out £80 as dividends. The remaining £120 is retained and added to the company's reserves.

CCC is a very predictable business and, whilst a private company, had been achieving steady profit growth over a number of years. Clive has a nice little niche business, and there is little threat of serious competition that would dent his returns. CCC is an ideal business with which to project forward a valuation based on its return on equity, taking into account its dividend payout and equity retention ratio. Here's how a 10-year projection would look:

Year     Equity     Profits   Dividend  Retained
0       1,000.00    200.00     80.00     120.00
1       1,120.00    224.00     89.60     134.40
2       1,254.40    250.88    100.35     150.53
3       1,404.93    280.99    112.39     168.59
4       1,573.52    314.70    125.88     188.82
5       1,762.34    352.47    140.99     211.48
6       1,973.82    394.76    157.91     236.86
7       2,210.68    442.14    176.85     265.28
8       2,475.96    495.19    198.08     297.12
9       2,773.08    554.62    221.85     332.77
10      3,105.85    621.17    248.47     372.70

Total Dividends             1,652.37

In year 0, the £120 retained earnings are added to the initial £1,000 equity to give a new starting position of £1,120. This scenario continues for the full 10 years. After 10 years, CCC's equity has risen from £1,000 to £3,105.85. That gives a compounding annual growth rate (CAGR) of exactly 12% (3105.85/1000 ^ 1/12).

Let's say that CCC traded at book value in year 0 of £1,000 and at book value again in year 10 of £3,105.85. If someone were to offer to buy the business from you at book value, your total return over 10 years of your initial £1,000 investment would be £3,105.85 plus dividend income of £1,652.37 = £4,758.22. Your CAGR would be 16.9% -- a damn good return, and much better than what you'd get by sticking your money under the bed or in the building society. We're ignoring taxes to keep things simple at this stage.

If CCC were quoted on the Stock Exchange, it may be valued quite differently to book value. Companies are traditionally valued by a multiple of earnings. Taking the thing a little further, here's some more assumptions based on the year 0 numbers:

 With profits expected to grow at 12% per annum, and the company trading at a price to earnings ratio (P/E) of 18, many investors may automatically assume the company is fully valued or even overvalued.

On a 10-year perspective, however, investors may see a slightly more favourable valuation for CCC. Let's presume over that period, CCC trades at an average P/E of 20, having hit a high of 35 in year 3 and a low of 12 in year 6. In year 10, CCC's profits are £621.17 (see above). Putting a multiple of 20 on those profits gives a market capitalisation of £12,423.40. Add to that the dividends of £1,652.37 you've received, and your CAGR based on a £3,600 market capitalisation starting point is an impressive 14.6%. It always makes good sense to calculate the potential high and low points of a company's valuations. With a year 10 P/E of 12, the CAGR would fall to 9.7%, and at the top end, with a P/E of 35, your CAGR would increase to a whopping 20.6%. You may decide that the upside potential outweighs the downside and buy all, or a part of, CCC.

The mix between retained earnings and dividends is a very important determinant of total returns. For example, if CCC retained 100% of its earnings, leaving them in the business to compound at the return on equity rate of 20%, over 10 years the book value would increase to £6,191.74 for a CAGR of exactly 20%. In a stock market situation, if you then whacked a P/E of 20 onto year 10 profits of £1,238.35, your £3,600 would increase to £24,766.95, for a CAGR of 21.27%. Some difference to the 14.6% CAGR we calculated when 40% of earnings were paid out as dividends. However (again), this is based upon the assumption that all the money reinvested in the business can earn a ROE of 20%. It may be that, due to limitations of its market, it cannot invest all its retained profits at this level.

You will see that we are always comparing the total value of the business. Instead of buying the whole business, if you bought 2, 20 or 200 shares in the company, the percentage returns would be exactly the same. By valuing the whole business, it keeps you focussed on the essence of share ownership -- you are a part owner in a company, not just owner of a piece of paper called a share certificate. In closing, just to reiterate, remember that this type of profit projection works on relatively few companies. It is usually effective on mature, established companies, and on ones that can sustain above average returns over a long period of time. These companies are few and far between.

More on valuation
1. Price to earnings
2. PEG
3. Price to sales
4. Dividend yield
5. Return on equity
6. Adjusting for goodwill
7. Uses of return on equity
8. Balance sheet basics
9. Discounted cash flow