Return on Equity (ROE) is one of the most common measures of profitability, business quality, and managerial performance. Many (and maybe even most) “quality” mutual funds and ETFs incorporate ROE as a key measuring tool and screening criteria. High ROE (that is not the result of too much debt…more on this later) also seems to be a key metric in Warren Buffett’s analysis. In one of his letters, he even said that sustainably high ROE was a “test of economic excellence.”
- “Most companies define “record” earnings as a new high in earnings per share…Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital.” – Buffett 1977 Letter
- “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.” – Buffett 1979 Letter
- “The Fortune study I mentioned earlier supports our view. Only 25 of the 1,000 companies met two tests of economic excellence – an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%.” – Buffett 1987 Letter
- “What we see in our holdings, rather, is an assembly of companies that we partly own and that, on a weighted basis, are earning about 20% on the net tangible equity capital required to run their businesses. These companies, also, earn their profits without employing excessive levels of debt.” – Buffett 2018 Letter
- “We own a small percentage of a dozen or so very large and highly profitable businesses with household names such as Apple, American Express, Coca-Cola and Moody’s. Many of these companies earn very high returns on the net tangible equity required for their operations.” – Buffett 2024 Letter
And here is a screen shot of Berkshire Hathaway’s acquisition criteria (for buying whole businesses) from its 2017 Annual Report:
From the above quotes and screen shot we can see that Warren Buffett (at least partly) looks for businesses with sustainably high ROE, while employing little or no debt. I also aim to invest in businesses that I think have sustainably high ROE because sustainable ROE is a driver of earnings per share (EPS) growth, and long-term stock returns are highly correlated to EPS growth (in other words stocks follow earnings higher over time).
The formula is…
Sustainable ROE x (1 minus the dividend payout ratio) = expected EPS growth
Let’s quickly put some numbers on this to demonstrate that sustainable ROE plus opportunities for reinvestment drive EPS growth. Let’s assume four companies each have a dividend payout ratio of 40%, meaning they retain 60% of earnings. A company with a 10% sustainable ROE will only generate 6% annualized EPS growth (once again assuming it pays out 40% of earnings as a dividend and retains 60% of earnings). A company with a 20% sustainable ROE can generate 12% annualized EPS growth. A company with a 30% sustainable ROE (and the same 40% dividend payout ratio) will generate 18% annualized EPS growth. And a company with a 40% sustainable ROE will generate 24% annualized EPS growth. Of course, this is merely theoretical as finding a business with a 40% sustainable ROE and ample reinvestment opportunities is hard to do.
Warren Buffett is also educating his readers that return on equity can be boosted with financial leverage (debt). In other words, Warren Buffett is incorporating a DuPont analysis when analyzing a business’s ROE. Now, he is probably doing it in his head with mental math faster than I can even type “DuPont Analysis,” but for me, as a mere investing mortal, I use a DuPont Analysis for every company in the Bastion Industrial and Infrastructure Portfolio (clients received a detailed DuPont break-down of each of the portfolio’s 28 holdings).
OK, so what is the DuPont model? Return on equity is calculated as net income divided by shareholders equity. Just as it sounds, it is a measure of a business’s net (bottom line) profits generated on shareowner’s capital. To perform a DuPont analysis, you only need four numbers, two line items from the income statement (sales, which is the top line of the income statement, and net income, which is the bottom line of the income statement) and two line items from the balance sheet (total assets and shareholder equity). The DuPont analysis decomposes the three drivers of ROE into (1) net income margins, (2) asset turnover, and (3) the leverage ratio so that:
ROE = net income/shareholder equity
ROE = (net income margin) x (asset turnover) x (leverage)
ROE = (net income/sales) x (sales/total assets) x (total assets/shareholder equity)
Net income margins are calculated as net income divided by sales and are a measure of profitability. Asset turnover is calculated as sales divided by total assets and is a measure of balance sheet efficiency. And the leverage ratio is calculated as total assets divided by shareholder equity. You can see that sales cancels out and total assets cancels out, so ROE is calculated as net income over shareowner equity.
The DuPont formula says that a company’s high ROE could be driven by high net profit margins or high asset turnover (balance sheet efficiency) or high debt or some combination of all three. And from the quotes above we can see that Buffett prefers high ROE to be driven by high net profit margins or high asset turnover, but not from debt.
While some companies do have high net profit margins and high asset turnover, that is rare. Rather many companies that have really high net income margins have lower asset turnover and companies that have really high asset turnover tend to have lower net income margins. But a select few companies do have both.
The third driver (the leverage ratio) is sometimes referred to as the “equity multiplier.” To understand why, we need to briefly review the balance sheet. The balance sheet is called the balance sheet because assets equal liabilities plus shareholder equity. That equation must always “balance.” The liabilities and owner’s equity are sources of capital (funds) and the assets are the uses of capital. In other words, a corporate management team (the CEO, CFO, etc.) use capital from debt holders and equity holders to invest in assets with the hope/expectation that those assets will generate enough earnings (profit) to earn an adequate return on those assets (ROA).
If Company A has $1 million in assets and $500,000 in shareholder equity, then we know it also has $500,000 in liabilities (debt) because remember that A = L + E. And that’s an asset-to-equity ratio of 2x. But now let’s assume Company B also has $1 million in assets but only has $200,000 of equity. Now it has $800,000 in debt (liabilities) and the asset-to-equity ratio jumps to 5x. In other words, company A and B both have $1 million in assets on the balance sheet, but company B is funding those assets with a lot more debt. And more debt means less equity (because remember the equation must balance) and equity is the denominator in the return on equity formula. And assuming the numerator (net income) doesn’t shrink, then a smaller denominator (smaller equity base) will lead to a higher ROE. And that is why debt can boost ROE and that is why the asset-to-equity ratio is also called the “equity multiplier.”
Here is another way to think about the equity multiplier. Remember that management teams use debt capital and equity capital to buy assets with the hope of generating a high-enough return on assets (ROA). Well ROA is calculated as net income divided by total assets so ROE can just be thought of as ROA multiplied by leverage. So, management teams can take a lower ROA and use leverage to generate a higher (in some cases much higher) ROE. But remember that the use of debt should be prudent. Moderate debt can boost returns to equity holders (and that’s a good thing), but too much debt can lead to financial distress and possibly financial ruin (and that’s a bad thing). You can see ROE is just ROA times leverage in the formulas…
ROE = (net income/sales) x (sales/total assets) x (total assets/shareholder equity)
That could be re-written as…
(net income/assets) x (total assets/shareholder equity)
And that could be re-written as…
ROA x Leverage
And that could be re-written as…
ROA x Equity Multiplier
OK, now I’ll share some details on the ROE of the portfolio I manage at Bastion Fiduciary. If I just take a simple average of the individual ROEs of all our holdings, in 2024 the Bastion Industrial and Infrastructure portfolio generated an average ROE of 40.8%, which is nearly double the S&P 500 average ROE in 2024 of 21% (according to Goldman Sachs). Twenty-two of the 27 holdings (I left one company out of the analysis because it was still a blank check for most of 2024) generated a ROE in 2024 above 20%, and five companies had an ROE below 20%. The portfolio holds six companies that generated a 2024 ROE above 50% (those ROEs were 223%, 91.9%, 82%, 66.2%, 53.3%, and 50.4%). The five 2024 ROEs that were below 20% were 17.5%, 17%, 16.6%, 14.7%, and 12.3%. In 2024 only two companies in the Bastion Industrial and Infrastructure portfolio generated both net income margins above 20% and asset turnover above 1x.
I’ll run this analysis each year, and if I remember (or if you remind me) I’ll gladly share it with you through the JRo’s Notes newsletter. Below you can find the DuPont breakdown for seven of the companies in the Bastion Industrial and Infrastructure portfolio. (Clients received the full chart). Notice that in 2024 NVR and Union Pacific both generated excellent ROE of 39.9%, but they did so with a vastly different combination of net income margins, asset turnover, and leverage (and the DuPont analysis allows us to see that). Also notice that JP Morgan Chase has a leverage (asset/equity) ratio of 11.61, which is much higher than all the other companies shown below. But banks, in general, generate ROA of about 1% so they lever up about 10-12x to generate a ROE of at least 10%. Keep in mind that before the global financial crisis (GFC) several banks were levered 20-40x so an asset/equity of 11.6 for a bank is actually quite moderate and according to Jamie Dimon, JP Morgan has a “fortress balance sheet.” OK, I’ll let you review the others on your own.
Disclosure: John Rotonti is an investor in and the portfolio manager of the Bastion Industrial and Infrastructure Portfolio, which owns shares of every company listed in the table. John also personally owns shares of Apple.
Disclaimer: This article is intended for informational purposes only and does not constitute tax, financial, or legal advice. Investing carries risks, including potential loss of principal. Consult a qualified professional for personalized recommendations and to ensure compliance with applicable tax laws and regulations.