This post was published to Just Analysis !

at 3:46:52 PM 5/11/2010

EPS or ROE? Choose Wisely.

Warren Buffett is one of the most amazing personalities in the investment world. First thing that
surprises someone is his past performance. Second his style of investment. Finally, it’s his words of
wisdom (shared through his interviews, articles and shareholders’ letters) that make your think
differently about things, market and life. Inspired by an interview of Prof. Sanjay Bakshi, a faculty at MDI
and CEO of Tactica Capital Management, I started reading Buffett’s Shareholder letters starting from
1977 available from Berkshire Hathaway website.

The first few paragraphs of the first letter made me realize the power of thinking of Mr. Buffett. The
letter contains the following lesson for investors –

Most companies define “record” earnings as a new high in earnings per share. Since businesses
customarily add from year to year to their equity base, we find nothing particularly noteworthy in a
management performance combining, say, a 10% increase in equity capital and a 5% increase in
earnings per share. After all, even a totally dormant savings account will produce steadily rising interest
earnings each year because of compounding.

The above 3-liner has a very important instruction hidden in it. As investors, what metric should they
choose to evaluate management’s performance – EPS or ROE? Honestly, it took me about 4 hours and
some net search to understand it. Finally I got an article, which elaborated what Mr. Buffett wanted the
investor to realize. Most companies show, in their results, how much growth they have achieved.
Growth in Gross Income, EBIT, PAT, EPS and asset size is very common. And yes, each of these is
performance measurement parameters which depict the outcome of efforts of management in utilizing
assets of the company.

EPS is a very common figure. Analysts compare the EPS of companies in the same sector and over a
period of time. What Mr. Buffett says in the above paragraph is that investors should not just be
mesmerized by the EPS number only. They should realize this that they have invested a particular sum
which gets increased every year because companies do not distribute their entire net earnings but
retain a portion for future investment or other uses of the company. To know, how much return an
investor has got over his investment, is depicted by ROE. Since retained earnings increase the equity
portion of the company, the management is expected to give the shareholders a return over this
amount (equity). Say a company has the following financials –

Year I II III IV
Beginning Equity 100 110 122 137.6
PAT 10 12 15.6 21.84
Ending Equity 110 122 137.6 159.44

Earnings Growth 20% 30% 40%

ROE 10% 10% 12% 15%
At a glance on the numbers we find that the PAT has increased significantly by 20%, 30% and 40% in the
four years. Looking at these numbers makes us pat the back of management for superb performance.
But the ROE numbers seem to be not extra-ordinary. We can see a rise in ROE to 15% over a four year
period, much below the PAT growth.

This is a very important realization for us as investors – even a savings account, which is not to be
managed by the investor and is more or less risk free, pays a 3.5% interest on the balance (that increases
by the amount of interest credited to the account every time). For investors who are risking their
money, they deserve an increasing ROE on their investment, which also gets increased by the amount of
increase in reserves.

To get a better sense of what Mr. Buffett says above, following are the PAT growth and ROE numbers for
top telecom companies included in CNX500.

Bharti 2009 2008 2007 2006 2005

EPS 40.79 32.9 21.27 10.62 6.53

Growth in EPS 24% 55% 100% 63%

ROE 34% 32% 35% 27% 26%

Growth in ROE 5% -9% 28% 5%
The above numbers, taken from ICICI DIRECT, make the concept clear. A remarkable increase in EPS is
not followed by a similar result in ROE. As an investor it should be the ROE which falls negative in the
year 2008.

There are many numbers that one can look at while making an investment. Understanding and utilizing
the numbers differentiates the investor/analyst.

Thanks for reading. Please leave your comment for correcting/improving the article.