Saturday, September 09, 2006

Return On Equity (ROE)

After we have found out what the intrinsic value of a company, we can compare the market value of the company with it to see whether the company is value for money. However, value is not the only decisive factor to judge an investment opportunity. One also have to research the company whether it is well managed and run efficiently. One of the figure to reflect this is : Return On Equity (ROE). The calculation is simple :
ROE = (Return / Shareholders' Equity) x 100%
But when working out this ratio, you should be very careful to exclude some one-time factors which may be misleading. For example, the tax exemption from Chinese Government to Chinese banks before their IPOs will lead to a better ROE performance but this ratio will decrease afterwards with the cancellation of such exemptions. From a general idea, you can easily obtain these data from financial websites :
For Hong Kong Stocks :
ROE is a correct measurement of the performance of the management of a company to show their effectiveness in getting the maximum return from available shareholders' equity. It is better than many other parameters such as Return On Asset (ROA), Earnings Per Share Growth (EPS) because it only takes into account the money invested by investors and truely reflects the return rate generated through these investments.
Warren Buffett is the one who really admire the power of ROE. He also stated that a company with a ROE above 20% can be good as the shareholders' equity will be doubled in 5 years if it can maintain a steady performance in ROE. Below is the ROE of top 5 investments of Berkshire Hathaway owned by Warren Buffett in 2005 :
1. The Coca-Cola Company (KO) : 30.41%
2. American Express Company (AXP) : 25.07%
3. The Procter & Gamble Company (PG) : 21.76%
4. Wells Fargo & Company (WFC) : 19.72%
5. Moody's Corporation (MC) : 185.6%
(Figures obtained from etrade website on 10th September, 2006)
Only one company ie WFC has a ROE slightly lower than 20%. The above figures are only the ROEs of the companies in the past year. In practice, please remember to average the ROEs of a company in the past years to get a steady judgement. Good Luck!
REMEMBER : Invest in a company with a ROE average better than 20% over a number of years will give an amazing return.