When you invest your money for the long term, for better or worse, someone else is going to manage it. Finding the best managers – either of mutual funds or individual companies – is a key challenge for a long term investor.
Google the phrase management performance’ and you’ll come up with some 4,830,000 entries. All sorts of metrics abound and there are plenty of advisers who’ll tell you their special approach is the one that provides deep insight into which companies do well.
I like to keep things simple. As an investor, did the management team run the company to increase my wealth?
In any company I invest in, my wealth along with all the other shareholders is actually a residual value. It’s the difference between the assets and liabilities of the company of fund. This is called shareholders equity. This concept equally applies to my approach to investing in mutual funds.
A company’s shareholder equity is retained earnings from previous years plus current year’s earnings less any dividends paid.
How can this change?
A company can make a profit and retain the earnings. Or it can increase the value of its assets. Or reduce the amount of its liabilities.
I like to see increased earnings. Changes in asset values or liabilities are subject to accounting conventions that are difficult for the untrained to assess. However, an increase in earnings can be generated from: operations; upgrading existing operations; or buying additional businesses. However, in itself, it isn’t a sufficient measure of performance for shareholders.
As Warren Buffett has shown, even a dormant savings account will show increased earnings (i.e. interest) year on year, if the interest is reinvested. So no management skill is required there.
Similarly, if the company is raising equity, shareholder equity in the balance sheet will increase. However, this does not add to my wealth or that of other shareholders. In fact, my share of earnings may be effectively reduced. The real question is whether the company’s growth rate increases faster than the reduction in my interest in the company.
For this reason I like return on equity.
This can be described as net income divided by average shareholder equity. It can be seen as a measure of how well a company used reinvested earnings to generate additional earnings. I use average shareholder equity to take into account any equity fund raising during the year.
There is also another reason I like return on equity.
Companies with high returns on equity typically throw off a lot of earnings that can be readily reinvested. This reduces their reliance on borrowing, minimises financial leverage and consequently financial risk. It’s a neat metric that allows me to quickly compare company performance in the same industry sector and across sectors.
So the next time someone tells you earnings are growing at 25% a year, ask them what that is as a return on equity.