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Return On Equity
At Cavallini Capital, we stress the importance of Return On Equity (ROE). No single metric is perfect when evaluating a stock and no single metric can tell an investor if a stock is a buy or not. However, ROE is probably the most consequential metric in terms of evaluating the efficiency and potential growth of how a company invests its profits for long term growth.
The question is, what does ROE tell us about a company?
ROE measures the efficiency with which a company uses shareholders’ equity. In other words, measuring profits per dollar of shareholders’. This means a company is using its capital efficiently which will increase shareholders’ capital at a faster pace. ROE gives us a quantifiable number to understand how productive management is at allocating capital.
Think of a fund manager that takes investors capital and compounds it 12% per year by investing in stocks versus another manager who only compounds at 8%. Clearly, an investor would pick the first manager. Same concept is true but with companies. Managers of a company invest their capital not in stocks, but in machines, marketing, people, etc.. These investments should pay off if properly deployed.
A consistent ROE of 20% or more is considered to be very good and illustrates the ability to correctly allocate capital. In the long term, the price of the stock tends to move in about the same fashion as ROE. However, it is critical not to over pay for a company even if the ROE and other metrics are fantastic. An investor should always have an idea of the fair value of a stock before investing. A Mercedes is an excellent car, but you would not pay the price of a Ferrari for it, same concept with a stock.
Let’s look at an example of ROE. Assume a business has $50 million in equity and it makes $10 million in profits. In other words, the ROE is 20%. The company does not pay a dividend and we put that $10 million in the bank. The bank gives us 2% percent interest (that is a stretch today), and the business continues to earn 20% on ROE on the original $50 million. That 20% will come down closer to 17% after the first year and 15% after the second year. Why?? Because the cash in bank earning 2% is blended in with the business earning a 20% return. So when you see a business consistently earning 20% or higher ROE, it means they didn’t simply put the profits in the bank, but instead used those profits and plowed them back in the company to increase sales and profits. This is the definition of correctly allocating capital.
A quick note on a possible issue with ROE. Companies can take on a lot of debt and boost their ROE without becoming more profitable. So it is a good idea to look at ROE alongside the company’s debt. I would argue that when evaluating a company, debt should always be taken into consideration.
At Cavallini Capital, we look for companies that can consistently generate ROE of 20% or more (there are some exceptions depending on industries). Our concentrated portfolio includes such companies which drive our great returns over the long term.
We are currently seeking investors to grow the Fund.
Please contact us at greg@cavallinicapital.com should you be interested.
To view track record, please contact Greg Cavallini at greg@cavallinicapital.com.