Think Like Warren Buffett
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Let’s be honest. Everyone likes a profitable business.
As a diligent investor, I prefer already profitable companies over companies that might become profitable someday.
And I use two metrics to compare companies:
· Return on equity (ROE)
· Return on invested capital (ROIC)
Which is better?
Here is a quote from Buffett himself: “A truly great business must have an enduring “moat” that protects excellent returns on invested capital.”
While reading Buffett’s Letters to Shareholders, I noticed he often talks about return on invested capital (ROIC).There are few mentions of return on equity (ROE)
But I want to discuss both today. Don’t worry. This won’t be a standard accounting lesson.
What is ROE?
This metric tells you how well a company is using its shareholders' money to generate profits. It's like asking, "Hey, how much bang for their buck are investors getting?"
ROE is expressed as a percentage and calculated by dividing a company's net income by its shareholder's equity. Basically, it shows you the return on the money invested by shareholders.
So, let's say you're checking out a company's ROE. A high ROE means the company is doing a fantastic job at making profits with the money shareholders have put in. It shows they're using those funds effectively and efficiently.
On the other hand, a low ROE might indicate that the company isn't generating much profit relative to the money invested. Keep in mind that ROE can vary between industries, so it's essential to compare it to similar companies within the same sector.
Now, let's move on to Return on Invested Capital (ROIC).
What is ROIC?
This metric takes a broader perspective. It measures how well a company is utilizing all the invested capital, including both equity and debt.
ROIC considers the return on both shareholders' money and borrowed money. It tells you how efficiently a company is using all the capital it has access to, regardless of whether it comes from investors or lenders.
Calculating ROIC involves dividing a company's operating income (income generated from its core operations) by its total invested capital (equity plus long-term debt).
Similar to ROE, ROIC is expressed as a percentage. A higher ROIC suggests that a company is generating strong returns on all the money it has at its disposal, regardless of where it came from.
Is ROIC better than ROE?
Before I answer this question, here is a comprehensive view of the two compared.
And while you skim it, feel free to think for yourself. Is ROIC better than ROE?
Let me give you a straightforward answer: ROIC is better, and here's why.
ROIC considers not only the money invested by shareholders but also the money borrowed through debt. So, it can't be manipulated as easily.
You see, companies have some flexibility in deciding how much equity to raise or dilute, which can affect the ROE calculation. They can also raise more debt or pay it off, which also affects ROE.
Let me break it down with an example.
Imagine two companies in the same industry: Company A and Company B. Both have the same net income of $1 million, but their capital structures are different.
Company A relies mostly on equity financing, while Company B has a significant amount of debt in its capital structure.
Now, let's calculate their ROE.
Company A has shareholders' equity of $10million, so its ROE would be 10% ($1 million net income / $10 million equity).
Meanwhile, Company B has shareholders' equity of $2 million and long-term debt of $8 million.
With the same net income of $1 million, Company B would have a ROE of 50% ($1 million net income / $2 million equity). So, you might think that company B is better since the ROE is superior. Well no, because the company is in danger due to high debt levels. This is a big problem of using ROE. And this is why Buffett prefers ROIC.
When we look at ROIC, it gives us a more objective measure of how effectively both companies are using their total invested capital, regardless of their capital structure.
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