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Home Guru Stocks Premium Screens Value Strategies Insider Trades Articles Forum Membership My Account List of Gurus Gurus Portfolios Stock Ideas Market Valuation Shiller P/E DCF Calc ulator Model Portfolios Scoreboard Tutorials Go Premium All News and Columns Search Articles by Stock Symbol, Guru Names, or Keywords: Understanding Warren Buffett's Preference For ROE Nov. 08, 2011 | Filed under: KO Print Email inShare Mara Kohn More Articles Follow1 followers It is widely known that the greatest investments are made in businesses with hig h ROE, especially on a long-term bias. ROE is one of the most important factors that Warren Buffett looks at when decid ing whether to make a deal or not. Why is it so important? Let's say you own Company A. It has $15 million in assets and $9 million in liab ilities, with shareholders' equity of $6 million. If Company A receives after-ta x earnings for $2,000,000, the ROE should be 33%. What happens if instead of owning Company A, you own Company B? Company B also h as $15 million in assets and $9 million in liabilities. The difference is that i nstead of making $2,000,000 on equity, it only makes $500,000. The ROE will be m uch lower; nearly 8%. Undoubtedly, Company A is better than Company B. It is more profitable, even tho ugh both have the same structure, and both are very well managed. The picture is much clearer with Company A. The ROE is significantly higher. Now

what would happen if you are given the choice to receive a $2,000,000 dividend from Company A? Would you accept it and thus pay taxes or would you keep the hol ding and see how earnings increase with the 33% rate of return? The second choic e is more seductive. But if you were the owner of Company B, would you keep the holding with an 8% of ROE or withdraw the $500,000 dividend? You understand why ROE is paramount. Let's pretend you don't own any of the two companies, but are in the market and you are willing to purchase one of them. You will probably consider each company 's situation and see if the owners are willing to sell. Well in this case, it's necessary to consider what Buffett believes about rates of return: They all comp ete with rates of return on government bonds. It is evident that the stock marke t goes up when interest rates go down and vice versa. A ROE of 12% on stock is m ore interesting than a government bond offering a 5%. But, if the interest rate goes up and the government bond ends up offering you a 12% ROE? Isn t it appealing ? Of course, the owners of Company A and B will go deep into this situation and se e if it is convenient. Company A earnings will amount to $2 million per year; so $25 million in governm ent bonds will be necessary to reach the former amount in interest. Company A's owner will sell the company at $25 million. If you buy it, you will be paying 12 .5 times Company A's current earnings of $2 million. Furthermore, you can only e xpect an 8% return in the first year. Company B earnings amount to $500,000 per year. Then, it would take $6.25 millio n to generate $500,000 in interest. You will have to pay $6.25 million to have i t and thus be paying 12.5 times the company's current earnings of $500,000. Just like in Company A, you can only expect an 8% return in the first year of owners hip. It seems there is now a different setting. However, bear in mind that for high r ates of return to exist you have to let compounding work. You should not be inte rested in the amount of earnings in one year. You must have a long-term planning . Now, if you calculate how the equity base will change from now to 10 years based on a 33% ROE and on an 8%, you will notice that Company A has more growing pers pectives than Company B. This is a hypothesis and you think that this calculation will never come true. T o make it more real, I'll take one of his best buys: Coca-Cola (KO). It is widely known that Coca-Cola has shown a 30% ROE since 1988. Warren knows i t very well, because in 1994 he bought a large position therein. This article aimed at showing you why ROE is important when deciding to invest i n business. This is part of Warren's foundation for success. It helps earnings t o increase and makes businesses much more interesting. I've definitely stoodd by it. Download the comprehensive GuruFolio Report of Warren Buffett Track Gurus Stock Purchases Daily Real Time Guru Picks GuruFocus "Real Time Picks" reports the stock purchases and sales that Gurus hav e made within the prior 2 weeks. The report time lag can be as short as 3 days a fter the date of the transaction. This is just one of the features provided with GuruFocus Premium Membership.

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