The favorite metrics of Warren Buffett & Charlie Munger↓
Continuing the Key Metrics series, we'll focus on two numbers: Return on Equity, or ROE, and Return on Invested Capital, or ROIC.
I group these metrics together here because, as you'll see later, they can reveal similar aspects regarding a company and their management. They're also favorite metrics of both Warren Buffett and Charlie Munger, so it may not be a bad idea to further analyze them.
Per usual in the Key Metrics series I want to start with the calculations and the meaning behind them. We'll start with Return on Equity and use Apple as an example.
Net Income / Average Total Shareholders' Equity
45,217 / ((128,249 + 119,355) / 2) = 0.365 = 36.5%
NOPAT (Operating Income * (1 - Tax Rate)) / Average Invested Capital (Total Shareholder's Equity + Debt - Cash)
(59,212 * (1 - 25.85%)) / (((128,249 + (11,605 + 75,247) - 67,155) + (119,355 + (10,999 + 53,463) - 41,601)) / 2)
43,905.70 / ((147,946 + 142,216) / 2) = 0.303 = 30.3%
Both ROE and ROIC are two decent return benchmarks that can be used on a variety of companies across many different industries. But there also great ratios to judge management, and competitive advantages, by as well.
That's all great, but how and why should we incorporate these two metrics in our investing approach. For instance, how do you go about deciding if a moat even exists? More importantly, is the advantage significant and potentially long lasting. While you should use your knowledge of the industry and the company, ROE and ROIC are two metrics that can assist you along the way.
So what numbers should you be looking for? Well, for reasons I'll explain in a little bit, I not only want to see ROE and ROIC above 15%, I want to see a trend of at least 5 years of over 15% and preferably increasing. Now let me explain why...
To briefly review, return on equity measures profits per dollar of capital shareholders have invested, while return on invested capital is the rate of return the firm makes on capital invested in itself. Charlie Munger has called this number the single best metric when it comes to determining if a competitive advantage exists. But both he and Warren Buffett have stressed the importance of both these metrics… so I figured maybe we should analyze them as well.
In fact, one of their letters to shareholders, from 1987, mentioned they use 2 tests to determine economic excellence. The 1st being the company had to have 10 years of a return on equity greater than 20%, and the 2nd stating the company couldn’t have any year worse than 15%. As you can imagine, not many companies fit the bill. According to a Fortune Magazine study, only 25 firms out of 1,000 passed from 1976 to 1986. The most astonishing number is 24, as in 24 out of the 25 companies outperformed the S&P 5oo during that timeframe. And since ROIC is close related, you should pay close attention to these metrics, they can tell you a lot.