Return On Equity (ROE) examines how the capital fund for the business’s asset and how the asset generates return based on your capital. If each $ of asset only generate each $ of earnings, it means the company is just merely cover its cost of capital. This indicate that the company at competitive disadvantages or simply low entry barrier of business. Therefore the earnings yield should be just on par with your cost of capital.
If a company has competitive advantage, the earning generated should be achieved higher than the cost of capital deployed. One has to know what the source of the business advantage is so that it is able to cross check the sustainability of the advantage whether it is due to the management’s strong capital allocation skills or by the business economic moats.
When you are projecting a growth rate on your earnings, it means you anticipate the company will growth at a higher growth rate than current cost of capital. You have to be certain that the future ROE is higher than past ROE. That is when your earning to growth measure comes in.
Finally ROE also break down into 3 components which are profit margin, asset turnover and leverage. Profit margin measure your cost efficiency and pricing power; asset turnover measure how fast your asset generate sales and leverage measure how much your borrowing is able to increases your capital structure.
After you are clear with the components of ROE, it is time to determine how powerful of the earning power does the company has. One of the ways is as shown: ROE> earning yield > cost of capital.
Here’s the explanation:
Value investing approach is to buy an asset below the intrinsic value. The cost of capital represents your opportunity cost or your hurdle rate.
Earning yield is what a company in normal cycle pays you including dividends and retained earnings to growth or maintains the business.
ROE is how efficient the companies allocating the capital to growth their earnings.
If it is a strong moat company, the financial statement should present ROE higher than earning yield as well as higher than your cost of capital (as shown as above).
If it is a normal company with competitive advantage, the ROE shall remain constant and the earning yield is normally higher than cost of capital.
If it is a competitive disadvantage company, the earning yield is equal to cost of capital. Asset valuation should focus at replacement cost.
All in all, enjoy the art of valuation and you may find the wonder in it.
