29. What is Return On Equity - Warren Buffett's Favorite Number Video Lecture | Become an Expert: Value Investing - Business Basics

welcome the course three unit two lesson
one return on equity Warren Buffett's
favorite number okay so as we go through
this lesson you're going to quickly
learn why return on equity is a really
important number that you need to
understand as a stock investor and you
understand why Warren Buffett places so
much emphasis on the return on equity
although this number doesn't substitute
understanding how the intrinsic value
calculator works that gives you a much
more in-depth understanding of what the
value of a company is the return on
equity number is a really quick snapshot
that you can look at and determine
whether a company is something that you
should be generally interested in so
when we value stocks we value them in a
very similar manner as the way we value
bonds and in 1977 Warren Buffett
actually wrote an article for Fortune
magazine and he wrote this article
before he became really famous and
well-known as a stock and bond investor
back in 1977 who's right on the cusp of
becoming well-known and that's whenever
he wrote this article and I have a link
to this article at the bottom of this
webpage where you're viewing the video
on the Buffett's books website so if you
just click on that link I highly
recommend reading this article in the
article we actually talks about more how
inflation eats away at bonds and
equities which is kind of contrary to
what John Berger will yems wrote in his
Harvard thesis and also goes against
what benjamin graham had wrote about in
the intelligent investor so it's a
really interesting article to read it
simply for that fact because he kind of
goes against the grain on those two
really important investment authors and
so I would read it for that reason alone
but also in there he talks about how he
values stocks and bonds similarly so I
think you'll get a lot of really good
information and a lot of good reading
out of that article but the reason I
mention this is because in order to
understand how return on equity works
you've got to kind of understand how
he's valuing stocks and bonds okay so
when we look at a bond the value of that
bond is all the all the money that
you're going to get out of the bond
throughout the duration that you own
okay when you figure out how much you're
going to get out of it you just discount
it back to what the present day value is
okay so when we're dealing with a bond
you're dealing with coupon payments
which are paid to you semi-annually and
then after the term expires on the bond
you get your par value back on the bond
which is typically $1,000 now when
you're dealing with stocks it's very
similar
finally there's just a slight difference
instead of receiving biannual coupon
payments instead you're receiving
quarterly dividend payments okay and
instead of receiving a par value back
it's based off the book value so how
much did the book value turn into by the
time you would go ahead and sell the
shares now if you never plan on selling
the shares then that book value will
hopefully just keep on growing and then
that will affect the value of your pick
so with a bond you're dealing with a
fixed coupon payment and with stocks
you're dealing with a variable dividend
payment depending on how the company
wants to pay you but you're still adding
up those payments and whenever the bond
matures because there's a term limit you
get your par value back with stocks
it's indefinite okay and you're basing
that value off of how the book value is
growing so that's why they're very
similar when you're figuring out that
intrinsic value whenever you go back to
the intrinsic value calculator that we
had in course 2 unit 3 all that's doing
is is it's using a discount rate or
discount calculator just like we use at
this contact later when we're valuing a
bond so it's a very similar technique so
the reason that all this is important
when you're understanding how the return
on equity number works is because that
book value as it's changing so that's
what we're going to focus on as the book
value here so let's say that we have a
generic company called company ABC and
we know that the company is traded at a
premium or a discount to that company's
book value so what we're going to say is
the company ABC has a book value of $10
a share
okay so depending on how this company
pays dividends depending on how this
company's been growing that equity or
book value and what the expectation of
how they can grow it in the
future that's going to determine how
much people are generally willing to pay
over the book value or below the book
value so how much they pay over the book
value or how much lower they paid from
the book value is is a function of how
fast they can add more money into that
book value so let's say the book value
is $10 right now well if they can add a
dollar of book value to to the company
in a year's time frame that's going to
be how investors base their opinion on
how much they're willing to pay over the
book value or under the book value so
let me demonstrate this okay so for
example let's say the company ABC had an
earnings per share of $5 a share
okay the EPS is $5 so this company could
grow their book value maybe by five
dollars in a one-year time frame because
right now the book value is $10 and
let's just assume that the company
doesn't pay a dividend all the earnings
goes into the equity of the business so
if they have an EPS a five and they
actually retain all that earnings back
into the business the book value next
year should be fifteen dollars okay so
that's substantial growth okay going
from $10 and book up to $15 in a
one-year time frame that's that's fairly
substantial so here's here's exactly
what I just talked about so when we look
at time now let's just say the time now
the book value is ten one year later
because the EPS was five and all that
money was retained into the company the
book value next year is $15 so if this
company let's just assume that this
company is trading right at its book
value okay let's just say that
generically okay so if the the market
price is $10 and next year they've added
five dollars to their book value but
most likely the market is going to
follow that trend in the markets then
going to value the company at at least
$15 a share because that's how much it
is if you tend the business today so you
can see that is that book value grows
the market price is gonna is going to
trend right with it and there's a quote
that warren buffett has that the change
in the book value over any given year is
equal to the intrinsic value change in
that
company so when we look at how much of a
game that was that was a 50% gain
because the company was able to add $5
to the book value which was 10 that's an
enormous gain that that company was able
to make so let's go ahead and do this
again but we're going to do it for a
different company we're going to do it
for company XYZ okay and I'm doing it
with a different company to highlight
why it's important to understand return
on equity and then I'm going to explain
it all here at the end so let's say that
we have a company XYZ in the book value
on company XYZ is $100 a share okay
and we're also going to make the same
assumption that people are going to
they're going to pay a premium or
discount to that hundred dollars okay
and let's say that X Y Z's earnings per
share is also five dollars a share okay
so they can grow their book value at
that rate they can't grow it any more
than that because they're not making any
more money than that so the most that we
could expect okay in one year time right
now is that they're their book value is
100 dollars per share next year if they
make an EPS of five dollars a share the
most they're going to be able to add to
the book generally speaking is five
dollars so when we look at that growth
okay we see that that's only 5% growth
okay and that's not all that much
especially when we compare it to the
other company that grew at 50% now the
thing that I want to highlight here is
that both of these companies company ABC
and company XYZ had the exact same EPS
they had the exact same earnings per
share okay but the difference was one
company grew at 50% and that market
price is going to trend right with that
book value so that market price would
probably have gone up 50% from where you
would have bought it one year previous
but then when you look at XYZ same exact
earnings but they only had a 5% return
and it was all because the book value is
so high because they had a book value of
$100 a share so what we're talking about
here is return on equity okay the equity
is the book value it's a it's book value
per share okay so when we look at our
equation for return on equity the return
on equity is the net income divided by
the shareholders equity okay and as you
know net income when you break that down
into a share per share basis that your
EPS and when you take equity and put it
down into a per share basis that becomes
book value so your ROA is really just
your EPS divided by your book value so
when we do that for these two companies
for ABC we knew that the EPS was five
and the book value is ten so our return
on equity was fifty percent but then
when we go over and we look at company
XYZ we see that they had the same exact
EPS of five dollars but the book value
was substantially higher at a hundred a
hundred dollars a share and so they'll
return on equity the best the company
could get was five percent so here's
here's the takeaway a steady or
increasing ROA is a company that knows
how to reinvest their earnings okay this
is important because most stocks retain
their earnings in the equity of the
business since whenever you whenever you
go out and buy a stock okay they're
going to pay you either through the
dividends or through retaining that
money into the equity of the business so
whenever a company is retaining those
earnings but their return on equity is
really small that's not good for you
because your market price is going to be
a reflection of that small change in the
book value so that's what you want to
stay away from so a declining return on
equity is symbolic of management that
doesn't know how to reinvest their
capital and successful assets and these
are the companies that you really want
to kind of stay away from and these are
these are companies that also should be
paying out all their money and dividends
because they don't know how to reinvest
it themselves so whenever I go and I'm
looking at a company and if Buffett you
know his he's really adamant about only
buying companies that sustain a very
high return on equity because he knows
that that management knows how to
reinvest that capital and since 75
percent of the money that's being made
is put back into the book value of the
business and not paid out as a dividend
he wants to make sure that that money is
being reinvested in quality assets that
are going to continue to make that high
rate of return and by the way he's not
paying any taxes on that money that's
being reinvested inside
company so that's the reason he wants to
find a company with a heart with a
really high return on equity I
personally look for companies that
sustain a return on equity above 7 to 8
percent so that's a rule of thumb that I
use and if you want to adopt that that's
up to you you can come up with your own
benchmarks but that's generally what I
personally look for so this concludes
course 3 unit 2 lesson 1 which is return
on equity and this is Warren Buffett's
favorite number so you're going to want
to make sure that you thoroughly
understand this and I hope to see you
guys in the next lesson