Tuesday, January 11, 2011

Volume 3 Issue 2: Intelligent Investing

Return on Equity

First and foremost, let me address why I am not doing a stock analysis just yet. What some of you may think as wasting time, I think it is important to go through some important terms and ideas before I jump into basic stock analysis.

The second reason is that the stock market is currently at a relatively high level and even though opportunities can be found, the margins of safety are being squeezed. This is by no means suggesting that I am timing the market. I have several stocks in mind that I believe are very strong companies. However, I think in waiting, we would probably be able to see their prices fall a little bit lower, thus, increasing our value for money.

Return on equity is probably one of the most important concepts for an investor. This is especially true for those who come from the Benjamin Graham school of thought. This is because of one of Ben's most famous catchphrases, "Investing is most intelligent when it is most business-like".

How does this even relate to return on equity (ROE)? First, let us just get a brief idea about what ROE means. The typical definition takes the ROE to be the ratio of net income to shareholders' equity. The only problem with such a definition is that, it does not tell you where to get the "net income" and where to get the "shareholders' equity". So, to put it in layman's terms, the ROE is a representation of how much profits a business earns as a proportion of its net assets. To break it down further, it simply means how much money you make (net income) from what you have (net assets = assets - liabilities).

Without going too far into technicalities just yet, we return to how ROE relates to investors. Since we have established that the ROE is the amount of money you make from what you have, it is probably of utmost importance as a business owner to maximize this value. And since an investor should think like a business owner, an investor should want a company that can consistently generate a high ROE because in the long run, that will essentially translate into returns for our investments.

I would like to stress on the importance of a consistently high ROE. This means that the company can consistently give us the most bang for our buck.

Now, how do we get this supposedly elusive Return on Equity figure from the financial highlights? For starters, based on the definition, we should look for the net income in the Income Statement in year 2010, for instance. However, the net income usually would have included some non-recurring expenses or non-recurring income. Thus, to be conservative, we should subtract off the non-recurring income, as well as add back the non-recurring expenses and make the necessary tax adjustments. We would then have obtained what is called the adjusted net income.

To get the other part of the ROE, we need the shareholders' equity. To be accurate in finding out how much we earn from how much we have, we should look at the shareholders' equity from the Balance Sheet in the year 2009 (the previous year). Because this would be the beginning balance of our net assets used to generate our earnings. This would be a good time to add that the shareholders' equity is usually equal to the net assets of a company, by virtue of their definitions.

Needless to say, we need to make some adjustments to the net assets as well. What I like to do is to remove the goodwill and intangible portions from the net assets because those two are basically monetary value placed on intangible items. Pardon the recycling of terms but intangibles are exactly what they are, intangible. Now, by dividing the adjusted net income in 2010, with the net tangible assets in 2009, we will obtain the adjusted ROE in 2010. Ideally, you should do this for every year for as far back as you can. But if you are feeling lazy, the minimum number of years you should go back to is five.

Now, the ROE is basically my screening criteria. I will only look for companies with a consistently "high" ROE. I would even go as far back as 10 years just to test how consistent the company is. Of course, it would be even better if the ROE is consistently growing. The question that should be ringing in your head right now is, what does a "high" ROE mean?

Well, that is a subjective matter, but it suffices to say that if you think like a business owner, the ROE should be the amount of returns that will satisfy you for your risk-taking. For me, I like to look at companies with ROEs that are at least 15%.

No comments:

Post a Comment