“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 consistent gains in earnings per share” – Warren Buffett
Return on Equity is a simple concept: take net income and divide by shareholder’s equity. Since both metrics are reported on a company’s 10-Q and 10-K forms every quarter, they are easy to make a rough calculation of and incorporate into your model of a company’s value. A quick look at this metric can help you understand how much you are paying for value, and how the value of a company’s business model is changing over time.
For instance, looking at Facebook’s (FB) 10-K for 2013, we see that the total net income for the company was $1.5 billion, and stockholders’ equity was $15.5 billion by the end of the year. Thus the company’s ROE was 9.7% by the start of 2014 (it’s much higher now), which tells us that every dollar put into FB should return 9.7 cents in pure profit by the end of every year.
This is an incredible return when measured against low-risk assets like U.S. Treasuries, but that’s an apples-to-oranges comparison. For one, FB is much higher risk. For another, it is a hyper-growth company. The question is whether its growth is likely to cause that ROE to rise over time, as the company produces greater net incomes that will reward flat or slightly rising equity at higher margins.
In other words, we are looking for Facebook’s the numerator in the ROE calculation (net income) to grow very quickly. And since this is what we are looking for, ROE is only a snapshot of how FB is doing right now on the road to its full growth potential.
From this perspective, the ROE metric isn’t terribly useful. And that’s no surprise; it isn’t used in tech, especially new tech firms, because tech is a hyper-growth category where investors look to bet on a high ROE many years down the line.
So, in the case of Facebook, what metric should you look at? Since we are looking at growth of net income, we need to ask ourselves what grows that income. Facebook doesn’t generate revenue from user payments—most of its revenue is now from advertisements. Facebook can generate that advertising revenue as long as people are using Facebook’s sites. Therefore, we can immediately determine that there are four metrics that are more important than FB’s ROE when valuing the stock:
- Growth of the company’s user base (total MAUs, new user registrations)
- Growth of the user base’s engagement on the platform (DAUs, MAUs, time spent online)
- Growth of the company’s platforms (acquisitions of additional platforms)
- Growth of advertiser spend on the platform (types of ads offered, placements of ads, performance of ads, cost of ads)
All of these are the behind-the-scenes metrics that drive Facebook’s revenue, so understanding these will, in turn, help investors understand just how much FB will grow its net income and thus provide a higher ROE.
Yet many analysts have done a very poor job of understanding these four concepts, which is why Facebook’s stock price has been so incredibly volatile since its IPO. It’s a new business and it’s a business whose revenue is driven by a business that asset managers, financial advisors, and analysts do not know very well.
This is where due diligence comes in to understand what sides of the company to measure to assess revenue. With that done, the next step involves assessing the company’s costs to understand how the firm’s earnings per share (EPS) will trend in the future. To do this, there are three issues investors need to analyze:
- Changes to the company’s costs driven by research and development
- Costs due to mergers and acquisitions
- Changes to operating costs that are necessary to manage the four growth drives discussed above
These issues are often quite easy to analyze and understand, since public firms announce acquisitions when they occur and will provide R&D costs every quarter. Unusual changes in operating costs will also appear in 10-Qs and 10-Ks, which is why it’s essential for analysts to pore over these four times a year.
Thus a mixture of financial acumen, curiosity about new business models, and an understanding of which metrics to follow is essential for any investor to outperform the market. Knowing which metric to use (revenue, EPS, ROE) for your company is important, but also knowing how your company’s business model operates and is changing is also important. Thus investors need to be comfortable doing all of these calculations, and they need to constantly be asking questions about top line, bottom line, and everything in between.