Getting the Market Right: Alexander Green Explains Return on Equity

Steve McDonald
by Steve McDonald, Bond Strategist, The Oxford Club

Transcript:

SM: This week, our guest is the Alex Green - the best mind in the money business. You’re probably sick of hearing me say that, but I believe every word of it.

AG: I never get tired of that, Steve. Go on.

SM: He’s here to talk about return on equity, and why he considers it one of his key indicators when he picks a stock.

Welcome, Alex!

AG: Hey, Steve, how are you doing?

SM: I’m great, thank you. Return on equity... it’s not one you normally hear people talking about, the talking heads on CNBC. You don’t usually read about it. What is it?

AG: Well, return on equity is essentially earnings per share divided by book value per share. And it’s an excellent measure of management’s efficiency with its use of the firm’s capital.

And even though I use it primarily for growth stocks, it’s actually Warren Buffett’s No. 1 metric when he’s evaluating stocks himself.

SM: I didn’t know that.

AG: His No. 1 metric, and I’ll tell you why.

Think about this: Sometimes value stocks become better values. Sometimes growth stocks fail to grow. There are lots of reasons why certain metrics don’t work out.

Earnings could be great, but then they could fall off a cliff. And book value could seem inexpensive, and then the company could take on debt or fall on hard times, and then the book value will change.

But return on equity is a very good measure of how the management is taking the shareholder equity and turning it into profits.

So you want to see a return on equity, generally, of 17% or higher. A lot of companies, when they’re on a growth streak, have a return on equity of 40%, 50%, even 60% or more.

It’s kind of rare, but certainly Microsoft back in the day, and Apple and Google and some of these great companies all had very high returns on equity.

So it’s a compliment to management if it’s doing a good job, and it’s also an excellent metric for measuring just how profitable the business really is.

SM: I don’t think I’ve ever seen a return on equity higher than the teens. Maybe 20%, but you’re saying there are some out there at 30% and 40%?

AG: Yeah. It doesn’t always last. For instance, I know that Microsoft had a 44% return on equity a few years ago, but I haven’t checked - it could be less than that now.

But you’ll find that when a company is going through a pronounced growth streak that the return on equity is generally high.

If you look at the CAN SLIM formula that William O’Neil, the publisher of Investor’s Business Daily, came up with, he looked at lots of metrics. He looked for double-digit sales growth and 20% or better earnings growth and all kinds of other metrics.

But he insisted, like Warren Buffett and like a lot of smart investors, that that high return on equity is there.

Because again, every firm has assets. Every firm has liabilities. But when you take those earnings per share, divide them by book value per share and look at what return on equity is, it gives you a real insight into just what kind of a business you’ve got.

SM: Is this the type of number that you can say, “Well, a threshold or minimum return on equity should be X”? Or does it vary from industry to industry?

AG: It varies from industry to industry. It varies according to the balance sheet and the debt structure of the company, because if you have more debt, you’re obviously going to have a lower book value per share.

But it’s still a good measure. You don’t use it alone. You still look at not only past earnings, but more importantly prospective earnings, and you look at dividends, and you look at cash flow and profit margins and other metrics as well.

So it’s just a tool in an investor’s kit. But still, it’s an excellent measure of management’s efficiency, so that’s why many of the great investors, including Warren Buffett, make sure that it’s something they can check off the list.

SM: Right. That sounds great. Where can a person go to find this number?

AG: One of the easiest places for the average investor to go is just Yahoo Finance. You put in the symbol for the stock, then you click on the link called “Statistics,” then you look down the left-hand side and you’ll find lots of metrics listed there... but one of them is return on equity, and you’ll see.

You asked, “What’s the threshold?” If you get, say, a return on equity of less than 10%, you’re looking at a company that could be seeing its profitability slip, or whose prospects for growing its profits are worsening.

So Yahoo Finance is an easy and free place to find that number.

SM: Yahoo Finance, return on equity and 10% as... kind of a minimum. Not a firm one.

AG: Higher is better, but I would be a little nervous if it were getting below 10%.

SM: Great. Alex, as always, wonderful information, thank you for sharing it with us.

AG: Thanks for having me, Steve.

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