What Return on Equity Shows Investment Bankers - dummies

What Return on Equity Shows Investment Bankers

By Matt Krantz, Robert R. Johnson

Investment bankers earn their paychecks by helping managers determine which actions are likely to result in an increase in shareholder wealth. But even if you can’t take actions that directly result in an increase in shareholder wealth, you can take actions that, over the long term, are highly correlated with rising stock prices. The surest way to achieve that goal is by helping a company increase its return on equity.

As the name suggests, return on equity measures how well the company is producing a return on the money supplied by stockholders — the ultimate owners of the company. It’s computed as:

Return on equity is also important because it dictates how quickly a firm is able to grow internally — that is, by reinvesting earnings. When a company earns money, it can do two things with that money:

  • Reinvest the money in the firm.

  • Pay out the earnings as dividends to investors.

Typically, firms retain some of the earnings in the firm and pay some out as dividends. One of the key items investment bankers must estimate is the long-term growth rate in the earnings of a company:

Long-Term Growth Rate in Earnings = Return on Equity × (1 – Dividend Payout Rate)

The dividend payout rate is simply what percentage of net income the company pays out in dividends. For example, if a company earns $100 million and pays $25 million out in dividends, the dividend payout rate for that company is 25 percent. If that same company could average a return on equity of 20 percent, then its long-term growth rate in earnings would be

Long-Term Growth Rate in Earnings = 20% × (1 – 0.25) = 15%

There is a direct trade-off between dividends and future growth. The higher the dividend payout rate, the lower the future growth. Essentially, investors can receive their return now in the form of higher current dividends or later in the form of higher earnings and, hopefully, a higher stock valuation.

Some companies pay out a relatively large portion of their earnings in the form of current dividends, while others choose not to pay any dividends and, instead, reinvest all their earnings in the company to provide for future growth. Investors know this and companies generally develop dividend payout policies that attract certain types of investors.

For example, many public utilities have very high dividend payout rates and are preferred by people who want to supplement their current income with dividend income.

Other more growth-oriented companies may have very low or no dividend payouts. Warren Buffett’s Berkshire Hathaway has never paid a dividend. And the shareholders of Berkshire Hathaway are quite pleased with that, because the firm has averaged a 19.7 percent compound annual return over 45 years from 1968 through 2012. Just $1 invested in Berkshire Hathaway in 1968 would’ve grown to over $3,267 by the end of 2012!

Take a look and see how consistently high Coca-Cola’s return on equity has been over the past ten years.

Year Return on Equity
2012 27.4%
2011 27.1%
2010 37.8%
2009 27.5%
2008 28.4%
2007 27.5%
2006 30.8%
2005 29.6%
2004 30.3%
2003 30.8%

Both the level of ROE and the consistency of ROE indicate that the Coca-Cola Company has a terrific business model and is incredibly well managed. These kinds of results are what firms strive to provide for shareholders.