Look through ROE

Posted by GRY on November 9, 2018

You know there is a model called FCV model. One of the models is to evaluate the quality of a business. The quality of a business can be divided into four parts: growth, profitability, stability and security. Buffett has said: “successful management performance, is to obtain a higher return on equity, not just the continuous increase in earnings per share.” So when it’s time to listen, listen to buffett. Recently, I just released my personal holdings for the second quarter. You found that only 1 of the 13 companies I own has an annualized ROE of less than 20%, and the average annual ROE of 13 stocks is 34%.

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Chinese translation of the ROE is numerous, has translated into shareholder returns, has translated into return on equity, and translated into shareholder return, return on net assets, return on net assets, return on equity, and so on, it’s stunt, we so far about financial class proper nouns don’t have standard translation, that simply don’t worry about how to translate, how simple how called, is called ROE.

Investor will not be familiar with ROE, but most investors are not completely full of ROE, and I find that many investment book are mentally retarded and that authors will simply tell you that ROE is more than 15% or 20% is good. The higher the ROE is, the better. The better or worse the ROE is not judged by just looking at a single number. The original, century-old formula used to profile ROE was invented by f. Donaldson Brown, an electrical engineer who joined dupont’s finance department in 1914. Of course none of this matters, you don’t have to take the test, but you do need to know that dupont’s formula breaks down ROE into three pieces: net interest rate, turnover rate, leverage rate.

ROE is generally explained by the following formula:

ROE= net profit/shareholder equity

Dupont’s formula is:

ROE= net interest rate x turnover rate x leverage rate.

The formulas are different and the results are the same. Why the same? We can decompose the net interest rate, turnover rate and leverage rate to obtain three formulas:

Net interest = net profit/sales turnover = sales revenue/total asset leverage = total assets/shareholders’ equity

Substitute the decomposed formula into ROE, namely:

ROE = net profit/sales revenue x (sales revenue/total assets) x (total asset/shareholder equity)

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And then the last thing you do is you subtract out the two sales revenues from the total assets and you get the first formula, so the two formulas are equal, but the dupont formula makes more sense. When we study the ROE of an enterprise, we must pay attention to its net interest rate, turnover rate and the continuous change trend of leverage rate.

First of all, the net interest rate, the net interest rate is what percentage of the money you actually earn from selling a product or service, it’s different from the gross profit rate, which is tax-inclusive, and the net interest rate is the deduction of all costs and taxes. This is a key indicator of the value of a brand, and the higher the net rate, the higher the value of the brand, the higher the value of the brand, the greater the value of the brand, and if a corporation has a higher net interest rate than a rival, then obviously, it’s a successful brand, and it can continue to be very successful, and we care about the continuing trend, and if the net interest rate is going to go down, then be careful, and it’s possible that the value of the brand is weakening.

Look at the turnover rate. This turnover rate is a narrow turnover rate. It only refers to the total asset turnover rate. It means that whether you borrow money or borrow equipment or your own money, you rely on all your existing assets. Create products and services, and finally, the amount of money you collect will account for all your assets. The turnover rate of a company is high. Obviously, its operation efficiency is high. This indicator is the lifeblood of small profits but quick turnover enterprises. For example, the wholesale and retail industry is typical. When we analyze the wholesale and retail industry, we must focus on the turnover rate. The so-called small profits but quick turnover, this multi-sale can actually be understood as the turnover rate, if you can’t sell more, then the turnover rate is very low.

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Finally, the leverage ratio is the same thing as the ratio of shareholders to equity and the ratio of assets to liabilities. It is just the formula and the results are different. The leverage ratio is the inverse of the equity ratio, so if you have $1 billion of assets and you borrow $2 billion, then the leverage ratio is 20 plus 10 divided by 10 is 3. This is a measure of whether a company is radical or conservative. Do you think it’s better to be conservative or radical? Of course neither is good, so leverage has to have a degree, it’s like human body temperature, 37 degrees is the best, then how to grasp this degree, degree is art not science, can not express, you have to experience. It should be said that leverage the index valuable, if you find a company’s ROE continue to rise, then you must check whether leverage ratios continue to rise, if a company’s ROE is rising up high leverage, so the ascension of the ROE is risky, so the ascension of ROE is best net rate and turnover. At present, there are some enterprises in the a-share market that use high leverage to achieve high ROE, such as some machinery stocks. Therefore, although I personally focus on machinery, I am watching dynamically.

In addition, the discretion of the ROE itself to have a reasonable scope, I more agree with pat dorsey, in his book really rules to limit, is 40%, higher than 40% ROE usually is useless, such as the company from the parent company, or the company to buy back shares, large price or products, or excessive high leverage, financial distortions, if a company’s ROE is more than 40%, then you have to be careful, read the results carefully, don’t be fool high ROE. The lower limit of ROE is usually 10%, which I think is better than 15%.

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ROE is like a box of jewelry, you only know if the jewelry is valuable if you open it. After all, high ROE is not necessarily good, and you have to dissect it. Most people said, it is easy to do investment difficult difficult in insist, in fact, this sentence is one of the biggest lies, it is not easy to do investment, you must spend time and energy analysis of corporate earnings reports carefully, do you want to know buffett to buy coke, coke over hundreds of years of earnings, it is as investors have to pay, you only have to understand the business, you didn’t have the confidence to hold, with confidence, that there is no stick to issue.