Return on equity (ROE) is one of the more commonly used ratios for determining how well a company can use capital. For the most part, earnings for share are a smokescreen, since it is only normal that a company grows its profits year by year and retains a proportion of these earnings, Buffett doesn't think a record high EPS for a company is anything special at all. In fact if a company is growing its earnings by 10% a year while at the same time growing its equity base by the same rate then Buffett really doesn't see this as anything different to putting your money into a 10% bond fund and reinvesting income so it compounds, the return is just the same so you might as well go for the bonds and take less risks.

In every book on Buffett you will find reference to Buffet's affection for ROE as a ratio he uses when analysing stock. Now I haven't actually spoken to Warren Buffett to see what he thinks of all the books that are written about him, but I do disagree in a minor way with the Buffett books.

ROE is a function of three variables: asset turnover, net margin and financial leverage. The DuPont ROE model expresses ROE as

            Revenues     Net Income            Assets 
    ROE  =  --------  x  ----------  x  -------------------- 
             Assets       Revenues      Shareholder's equity

          Net Income
     --------------------
     Shareholder's equity

            Assets
     --------------------
     Shareholder's equity

     Revenues      Net Income  
     --------  x  ----------- 
      Assets        Revenues  

      Net Income
      ----------
        Assets
 

The typical Buffett company is one that is able to generate huge profits without having to invest a lot of money to achieve those profits. Companies like See's Candies, Coke and American Express are able to achieve a very high return on assets because these businesses are able to expand without needing massive capital expenditures and because competitive advantages brought on by their franchise nature allow them to raise prices without hurting sales.

Here we have a problem in that assets can be fairly hard to value and may be reported in a variety of ways under Generally Accepted Accounting Practices, including being carried at cost, showing depreciated values or at replacement values. I think this is a minor problem though since you probably need to know about asset costs anyway when calculating shareholder's equity, and since return on assets nicely cuts out stock pricing from the equation I think looking at a company's return on assets sounds more like the kind of analysis Buffett is thinking of.

Of course you can't just use a straight out return on assets without making a few corrections. Buffett excludes from net income all capital gains and losses as well as extraordinary items. He wants to see how a company is growing its annual returns, given the capital that it employs. This is probably the most valid way to measure management's economic performance.

Earlier on in the FAQ I discussed "economic goodwill". It is obvious that a company with a high return on assets is going to be a company that creates economic goodwill. When the ROA is higher than the cost of borrowing, the company can expand and provided it does not create any overcapacity it ought to be able to grow its profits at a staggering rate just by investing more money to buy more assets like the ones it already has. Any company with a ROA lower than the cost of borrowing has a very limited capacity to expand and would be better off being sold off. Referring to another article, a rational manager with an abundance of cash ought to be buying back stock if ROA is high and they can't reinvest in the business, or paying out the money as a dividend if ROA is low.