High return on equity stocks at a reasonable price?

[scorpioncapital]

Is there a list of high return on equity stocks at a reasonable price? I was reading that Buffett believes a good business is key.

 

However, it seems some filters are in order

 

- the high return is not due in large part to debt or if there is debt, if you divide by the debt, the ROE is still high.

 

- the high ROE is not due to a cyclical business at a high point in the cycle.

 

- the price is reasonable or in fact more than reasonable right now.

 

- You or someone you respect understands the business well if it's in tech and you're pretty convinced of this assessment.

 

- If ROE is not high now but is about to be high for many years due to key business trends.

 

 

[west]

I'm not answering your question as you asked it, so apologies for that.  However, for what it's worth, I no longer consider ROE (unless I'm looking a grossly overcapitalized company, like some of my Japanese stock recommendations).  I only look at ROIC.  I do this because ROE can really be distorted.  It can be distorted by capital structure (high debt can mean higher ROE, which doesn't necessarily translate into a higher justified equity value), tax effects (tax rates in different areas or NOLs for one company and not for the other), and other income (by default, if you don't adjust them out, one time income items will show up in net income, which is the numerator for ROE).

 

So I would skip ROE (and Market Cap based ratios) and stick with ROIC (and EV based ratios) imho.

 

[scorpioncapital]

It would seem both ROIC and EV are similar in that they include debt. As such, does it imply lowering return expectations since adding debt to the denominator would almost certainly reduce the return. I.e. If a company earns 20% on equity with no debt and then it adds debt equal to equity but does not increase earnings much, returns now go down to 10%.

[west]

It would seem both ROIC and EV are similar in that they include debt. As such, does it imply lowering return expectations since adding debt to the denominator would almost certainly reduce the return. I.e. If a company earns 20% on equity with no debt and then it adds debt equal to equity but does not increase earnings much, returns now go down to 10%.

 

I'm not 100% sure I understand, but whether debt adds to the equity value of a firm is determined by the company's return on the capital that was provided by that debt.  In other words, if they pay 10% interest on the debt (after the tax deduction), but they only return 10% on the investment they made from the money from the debt, the equity gained no value.  If they are able to get 20% returns on that new money, some value does accumulate to the equity.

 

For what it's worth, you should never look at the value of the equity alone.  You should only look at a company in the "firm" or "enterprise value" sense -- the total value of it.  If you can't do this, you need to go back to square one, or you're going to make mistakes that you don't want to make.

 

I highly recommend going through Aswath Damodaran's lectures.  He posts them online for free (a top NYU MBA class... normally requires $100k+ in tuition plus two years of your life... for free).  You can get through them in a month if you can dedicate the daily time to watching them.

 

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcasteqspr14.htm

 

(I link to the spring classes because they're all there.  The fall session isn't all there yet.)

 

[oddballstocks]

west, how are you calculating ROIC?

 

I used to use FCF/Invested Capital, with invested capital being equity plus debt plus leases minus cash.  This essentially gives cash return on cash outlays.

 

 

[west]

west, how are you calculating ROIC?

 

I used to use FCF/Invested Capital, with invested capital being equity plus debt plus leases minus cash.  This essentially gives cash return on cash outlays.

 

That's the million dollar question.  I'm on my phone so I won't be answering this as well as I'd like.

 

In general, there are two approaches.  The first is what I like to call the Greenblatt approach, which is EBIT / (Net Working Capital, minus Excess Cash + Net PP&E).  This ignores Goodwill and potentially a bunch of other stuff.  The other approach is what I like to call the Damodaran approach, which is (EBIT * (1 - Tax Rate)) / (Book Value of Equity + Book Value of Debt - All Cash).

 

There are pros and cons to both approaches.

 

The problem with *both* approaches is that EBIT is the numerator under the assumption that Depreciation = Maintenance CapEx (MCX), which is not the case for anything except for maybe stable firms.  The numerator really should be Free EBITDA, which is EBITDA - MCX.  You can determine an approximate MCX using quantitative methods, but it is too complex to describe via typing on my phone.

 

(Oh, also there's ROIIC, which is Return on *Incremental* Invested Capital, which is just as important, if not (potentially) more important, than ROIC.  It measures how much return you're getting on *new* capital investments.)

[west]

Fwiw, I can't remember if the PV of leases is actually appropriate to include in the denominator of the calculation.  I'll have to look it up/think about it.  As of right now, I'm thinking they shouldn't be there...

[oddballstocks]

Fwiw, I can't remember if the PV of leases is actually appropriate to include in the denominator of the calculation.  I'll have to look it up/think about it.  As of right now, I'm thinking they shouldn't be there...

 

Thanks for the responses, I guess the book I was reading used a more Damodaran approach.  On leases, they're off balance sheet, but they are still capital invested that's required to run the business.

 

Think of it this way, if you owned a donut shop and leased space I'm sure you'd calculate your return after your rent payment.  Ignoring the rent provides artificially inflated numbers.  Without the location you have no business.  The next question then becomes what's the correct discount rate for the leases.

[west]

Fwiw, I can't remember if the PV of leases is actually appropriate to include in the denominator of the calculation.  I'll have to look it up/think about it.  As of right now, I'm thinking they shouldn't be there...

 

Thanks for the responses, I guess the book I was reading used a more Damodaran approach.  On leases, they're off balance sheet, but they are still capital invested that's required to run the business.

 

Think of it this way, if you owned a donut shop and leased space I'm sure you'd calculate your return after your rent payment.  Ignoring the rent provides artificially inflated numbers.  Without the location you have no business.  The next question then becomes what's the correct discount rate for the leases.

 

Again, I still need to look into this (and see what people smarter than me have said), but current rent expense is included in EBITDA.  There's no reason to double count it by bringing the PV of *future* leases into the ROIC calculation.  After all, you're looking at your *current* invested capital and current returns.

 

I think (emphasis on "think") the PV of leases is appropriate to include in EV, but not in IC.

[west]

I double-checked Damodaran (wooo for a very socially active Wednesday night), and he doesn't bring in the PV of leases, nor does Greenblatt.  However, I do see a couple of sources that say that you should (Investopedia, for example).

 

I guess my feeling at this point is IC should include the money that's been sunk into the business so far, not the money that will need to be sunk (*ahem*... "invested") in the future.  After all, extending the life of my business's leases will increase the present value of my total liabilities, but it won't decrease my current economic returns.

[SpecOps]

I wrote a whole article about designing a stock screen to find these kind of companies while not letting good candidates fall through the cracks.

 

Typical ratios like ROE and ROIC can appear temporarily bad because of one bad year with writeoffs, so important to try and catch them in a screen to, and I do that by using gross profit where i can and adjusting the cut off appropriately

 

http://investingsidekick.com/improve-stock-screens/

[vinod1]

I was re-reading Damodaran's "Investment Valuation" book the last few weeks and he emphasizes  that we make the following adjustments, so when he says debt he means adjusted debt.

 

Adjusted Debt = Interest-bearing Debt + Present Value of Lease Commitments

 

Adjusted Operating Income = Operating Income + Operating lease expense in current year – Depreciation on leased asset

 

This adjustment would correct both numerator and denominator in calculating ROIC.

 

Vinod

[KCLarkin]

To answer the original question, https://www.magicformulainvesting.com/ was designed exactly as a screen for this. Most of the stuff that shows up isn't Buffett quality though.

 

I don't use it is a screen but I do sometimes check to see if something I am buying is on the list.

[scorpioncapital]

I don't see how including debt can determine quality of business. It seems return on equity is the only measure of quality businesses. If a business earns high ROE due to debt, it's not due to the business quality but the leverage factor unless one condition is met - it can earn the same return on the debt which means incredible ability to scale up. This may be the case for the best of the best but most are just juicing the leverage factor at a much lower return than their core return.

[west]

I was re-reading Damodaran's "Investment Valuation" book the last few weeks and he emphasizes  that we make the following adjustments, so when he says debt he means adjusted debt.

 

Adjusted Debt = Interest-bearing Debt + Present Value of Lease Commitments

 

vinod1, but he uses the Book Value of Debt, NOT Adjusted Debt, in the denominator of the ROIC calculation.  Adjusted Debt is used in other locations, like in the EV calculation.

[west]

I don't see how including debt can determine quality of business. It seems return on equity is the only measure of quality businesses. If a business earns high ROE due to debt, it's not due to the business quality but the leverage factor unless one condition is met - it can earn the same return on the debt which means incredible ability to scale up. This may be the case for the best of the best but most are just juicing the leverage factor at a much lower return than their core return.

 

ROIC measures the quality of the whole business regardless of capital structure (high debt, low debt, no debt, whatever).  ROE is capital structure *dependent.

 

Debt levels do not effect the "quality" of a business.  They only measure how much of the business (the slice of the "pie") belongs to the debt-holders versus the equity-holders.  (At least for the sake of this discussion.)

[KCLarkin]

I don't see how including debt can determine quality of business. It seems return on equity is the only measure of quality businesses. If a business earns high ROE due to debt, it's not due to the business quality but the leverage factor unless one condition is met - it can earn the same return on the debt which means incredible ability to scale up. This may be the case for the best of the best but most are just juicing the leverage factor at a much lower return than their core return.

 

ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net profit/Sales)*(Sales/Assets)*(Assets/Equity)= (Net Profit/Equity)

 

- Profitability (measured by profit margin)

- Operating efficiency (measured by asset turnover)

- Financial leverage (measured by equity multiplier)

 

If you are using traditional ROE, you are implicitly valuing high leverage equal to high profitability or efficiency. So if you are using ROE, you need to adjust for the debt somehow (e.g. filter out high debt companies).

[oddballstocks]

I don't see how including debt can determine quality of business. It seems return on equity is the only measure of quality businesses. If a business earns high ROE due to debt, it's not due to the business quality but the leverage factor unless one condition is met - it can earn the same return on the debt which means incredible ability to scale up. This may be the case for the best of the best but most are just juicing the leverage factor at a much lower return than their core return.

 

Let's say there are two companies, the first one puts in $100 and generates $10 in earnings, a 10% return on capital.  The second one puts in $30 in cash and $70 in debt and makes the same $10.  You're saying that second business is 'better' because it's earning 30% on equity.  I disagree with this statement.  You need to include the full capital structure. 

[scorpioncapital]

Sounds like you have to remove the % of income & interest due to the debt, if there is a way to separate this out.

[west]

Sounds like you have to remove the % of income & interest due to the debt, if there is a way to separate this out.

 

EBIT is Earnings Before Interest and Taxes.  So interest expense is removed, as I believe you are suggesting.

[vinod1]

I don't see how including debt can determine quality of business. It seems return on equity is the only measure of quality businesses. If a business earns high ROE due to debt, it's not due to the business quality but the leverage factor unless one condition is met - it can earn the same return on the debt which means incredible ability to scale up. This may be the case for the best of the best but most are just juicing the leverage factor at a much lower return than their core return.

 

To paraphrase Buffett, what you really want to measure is return on tangible invested capital. We can calculate invested capital either two ways (1) Net working capital + Long term tangible assets or (2) Debt + Equity. The second method is simpler.

 

Vinod

 

 

[vinod1]

I was re-reading Damodaran's "Investment Valuation" book the last few weeks and he emphasizes  that we make the following adjustments, so when he says debt he means adjusted debt.

 

Adjusted Debt = Interest-bearing Debt + Present Value of Lease Commitments

 

vinod1, but he uses the Book Value of Debt, NOT Adjusted Debt, in the denominator of the ROIC calculation.  Adjusted Debt is used in other locations, like in the EV calculation.

 

West,

 

Yes, he does mention book value of debt but I think that is because he introduces this equation on page 44 of a 992 page book. He talks about leases in detail much later in the book. He keeps hamming away throughout the book that operating leases are functionally equivalent to debt and should be treated as such. In the examples, he keeps adding PV of leases to debt.

 

In the section on "What is Debt?" on page 214, he makes this very clear that debt should include capitalized operating leases. To him there is no difference between the two.

 

Vinod

[scorpioncapital]

So let's say a company has $1 in equity and $1 in debt. It earns 50 cents. Return is 25%. Can you ever know what the return would have been if they didn't employ the $1 in debt? If the debt earns at the same rate as equity, then it's 1:1. But what if the equity was earning far more than the new debt so that the incremental debt earns far less. Haven't ever seen a company break this down.

 

 

[Liberty]

The book Valuation published by McKinsey has interesting stuff on how to think about ROIC and growth. I recommend it, especially the first half.

 

http://www.amazon.com/Valuation-Measuring-Managing-Companies-Edition/dp/0470424656

[TwoCitiesCapital]

I think we're getting bogged down at differing levels of granularity.

 

Let's say you have a business opportunity that requires capital. For every dollar of capital it will return 15% on that cspital prior to the cost of that capital. This 15% is generally considered a great return (depending on inflation, cost of capital, and alternatives).

 

This is a great business opportunity and is identified by EBIT/Capital which comes out to be an ROIC of 15%.

 

Now, just because it's a great business opportunity doesn't mean the company is great. The company could choose to fund themselves with $1 of equity and $99 of debt. Return on equity would be close to 15x but any air pocket resulting in 1% hit to assets would result in total loss of investment.

You could also have a company that does $100 equity and esrns 15% on that pretax. This is great but isnt leveraged and amounts to having 15x as much money up front to begin (or selling a piece of the future profits of a wonderful business opportunity).  As we can see, the opportunity was the same but each company capitalized differently leading to significantly risk/rewards for shareholders.

 

ROIC identifies good business opportunities. ROE is indicative of how a company is capitalizing to take advantage of that opportunity. ROIC is hard to fudge and change without changing the business opportunity. ROE is as simple to adjust as adjusting capital structure.

 

Basically use ROIC to determine good opportunities. Use ROE to determine how best, and how much risk, is being takem to exploit those opportunities.