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Effect of buybacks, dividends, and debt on incremental ROE


scorpioncapital
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When a company retains all earnings and doesn't use too much debt it's easy to see the return on equity and incremental equity because you just divide earnings by the increasing cash and assets purchased. Something like Berkshire for example.

 

Where I get a bit confused is when companies play all these buyback, dividend, and debt restructuring games, which is pretty much 80% of them.

 

The paradox seems to be that many good businesses have high ROE IF you remove the retained cash. Sort of like taking the money out of the bank account and saying my core business has great performance. However this doesn't tell you if the company can get a return on the total capital or grow.

 

Should an investor do a simulation assuming the buyback or dividend wasn't paid to see the real management's ability to have a high ROE in the face of increasing cash? Or should one look at lack of opportunity and just the return of the core business and take the dividend and assume you can invest it elsewhere.

 

E.g. Buffett does this when he buys something like IBM, a high dividend/buyback payor that cannot grow (at the moment) but which returns to him some money to invest elsewhere.

 

Using IBM as an example again. Assume all they need is working capital of $20 billion to earn $13 billion per year. This is a very high 65% ROE. For all intents, the ROE is infinite as you can just say it earns $13 billion on virtually nothing but people, patents, and expenses everything annually.

 

Ok...so if IBM retained all $13 billion every year for 10 years, they'd have $130 billion in the bank. Now , their ROE goes down to 10%. Clearly without growth in earnings, IBM is like a bank account with diminishing ROE. But if they clear out the balance , you can see the core business does have a high return.

 

So do investors look at earnings growth to determine how a company might earn a high ROE in the face of retaining earnings? Would you say a business was 'good' if it had to clear out the gains, had no growth, but allowed you to reinvest the funds elsewhere via dividends?

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