Warren Buffett is one of the most amazing personalities in the investment world. First thing that surprises someone is his past performance. Second his style of investment. Finally, it's his words of wisdom (shared through his interviews, articles and shareholders' letters) that make your think differently about things, market and life. Inspired by an interview of Prof. Sanjay Bakshi, a faculty at MDI and CEO of Tactica Capital Management, I started reading Buffett's Shareholder letters starting from 1977 available from Berkshire Hathaway website.
The first few paragraphs of the first letter made me realize the power of thinking of Mr. Buffett. The letter contains the following lesson for investors –
Most companies define "record" earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.
The above 3-liner has a very important instruction hidden in it. As investors, what metric should they choose to evaluate management's performance – EPS or ROE? Honestly, it took me about 4 hours and some net search to understand it. Finally I got an article, which elaborated what Mr. Buffett wanted the investor to realize. Most companies show, in their results, how much growth they have achieved. Growth in Gross Income, EBIT, PAT, EPS and asset size is very common. And yes, each of these is performance measurement parameters which depict the outcome of efforts of management in utilizing assets of the company.
EPS is a very common figure. Analysts compare the EPS of companies in the same sector and over a period of time. What Mr. Buffett says in the above paragraph is that investors should not just be mesmerized by the EPS number only. They should realize this that they have invested a particular sum which gets increased every year because companies do not distribute their entire net earnings but retain a portion for future investment or other uses of the company. To know, how much return an investor has got over his investment, is depicted by ROE. Since retained earnings increase the equity portion of the company, the management is expected to give the shareholders a return over this amount (equity). Say a company has the following financials –
Year | I | II | III | IV |
Beginning Equity | 100 | 110 | 122 | 137.6 |
PAT | 10 | 12 | 15.6 | 21.84 |
Ending Equity | 110 | 122 | 137.6 | 159.44 |
Earnings Growth | 20% | 30% | 40% | |
ROE | 10% | 10% | 12% | 15% |
At a glance on the numbers we find that the PAT has increased significantly by 20%, 30% and 40% in the four years. Looking at these numbers makes us pat the back of management for superb performance. But the ROE numbers seem to be not extra-ordinary. We can see a rise in ROE to 15% over a four year period, much below the PAT growth.
This is a very important realization for us as investors – even a savings account, which is not to be managed by the investor and is more or less risk free, pays a 3.5% interest on the balance (that increases by the amount of interest credited to the account every time). For investors who are risking their money, they deserve an increasing ROE on their investment, which also gets increased by the amount of increase in reserves.
To get a better sense of what Mr. Buffett says above, following are the PAT growth and ROE numbers for top telecom companies included in CNX500.
Bharti | 2009 | 2008 | 2007 | 2006 | 2005 |
EPS | 40.79 | 32.9 | 21.27 | 10.62 | 6.53 |
Growth in EPS | 24% | 55% | 100% | 63% | |
ROE | 34% | 32% | 35% | 27% | 26% |
Growth in ROE | 5% | -9% | 28% | 5% |
The above numbers, taken from ICICI DIRECT, make the concept clear. A remarkable increase in EPS is not followed by a similar result in ROE. As an investor it should be the ROE which falls negative in the year 2008.
There are many numbers that one can look at while making an investment. Understanding and utilizing the numbers differentiates the investor/analyst.
Thanks for reading. Please leave your comment for correcting/improving the article.
