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A business first and foremost in the realm of Warren Buffett is an investment; it is not merely a job or a means to an income as seen through the typical eyes of a small business owner. Although personal income is certainly a priority in small business, it should always be subordinated to the business as an investment in order to build a small business that Warren Buffett would love. In order to traverse the col from small business owner with an emphasis on income to small business owner with an emphasis on investment it is imperative to have the ability to calculate return on equity. Warren Buffett considers the return on equity to be his rate of return in the stocks of the companies he invests in. A small business owner with a focus on return on equity can evaluate the business based on return, determine if it is generating a strong or mediocre return and make a forward-moving investment decision.
Painting The Picture of Return on Equity
Simply put, return on equity is a measure of how hard the equity in a business is working.
ROE = Net Income / Shareholder’s Equity
Net income can be found on the income statement and equity can be found on the balance sheet. In a small business with one owner, all of the equity technically belongs to the single owner, the single shareholder. All things equal, a business investment with a 20% return on equity is superior to a business investment with a 10% return on equity.
Why So Important ?
As you can see from our ROE formula, a business with a strong return on equity is delivering a healthy amount of income using the least amount of equity possible. (the numerator is big, the denominator is small.) Back to our comparison mantra, we don’t necessarily want to throw $100,000 worth of equity into a business generating a 10% return on equity or $10,000 a year when we can invest it in another available option that is firing at 20% which will deliver us $20,000 a year in income. More is better right when it comes to income and business?
For an existing business, a low return on equity is an indicator of a problem … danger, danger Will Robinson! If after obtaining your handy, dandy industry comparison report you find that your business should be chopping away at a 15% return on equity, I would argue that the competition in town is probably eating your lunch … and sooner or later they will be eating your dessert as well: the competition is utilizing their equity more efficiently leaving them more income at the end of the year to potentially reinvest and grab more market share. Better start tweaking your return on equity!
And Now Some Examples
Below are three, 10 year track records of three consumer monopoly companies that Warren Buffett was at one time or currently, absolutely in love with: McDonald’s, Coke and Wal-Mart. Above all else, this picture should give you a crystal clear, expectation of what to look for in order to build a business that Warren Buffett would love. Remember, return on equity is found by dividing the net income off of the income statement by the equity found on the balance sheet.
Ten Year Return on Equity for Three Consumer Monopolies
| | MCD | KO | WMT |
| 2001 | 17.51% | 38.38% | 20.08% |
| 2002 | 9.04% | 26.33% | 21.60% |
| 2003 | 13.22% | 33.58% | 21.83% |
| 2004 | 17.40% | 32.29% | 22.08% |
| 2005 | 17.73% | 30.18% | 21.90% |
| 2006 | 23.16% | 30.53% | 19.67% |
| 2007 | 15.58% | 30.94% | 20.18% |
| 2008 | 30.01% | 27.51% | 20.63% |
| 2009 | 33.20% | 30.15% | 21.08% |
| 2010 | 34.51% | 42.32% | 23.53% |
| Average ROE | 21.14% | 32.22% | 21.26% |
McDonald’s: the name alone brings to mind those golden, crispy potato slices of salty goodness … good and good for you. (although I am being slightly facetious here, in recent years, McDonald’s has made “healthy” strides in fry technology opting to cook them in vegetable oils instead of just plain old lard, the latter of which I believe made the fries much tastier.)
Look at that golden, crispy, return on equity over the years. Despite a very anemic 2002 at 9%, we see a steady, strong march through the mid to upper teens and into the lower 30% range in the late 2000s resulting in a hearty, 10 year, average return on equity of 21%. Beat that Colonel Sanders! (editor’s note: the squinty eyed, bolo-tie wearing, senior commissioned officer connoisseur of fried poultry has in fact annihilated this number … over the past 5 years, as part of the Yum brands portfolio, KFC and its Yum counterparts have averaged a 131% return on equity! That’s a lot of chicken!) McDonald’s exemplifies a steady, strong and growing return on equity.
Coke: In my opinion, Coke nowadays is synonymous with the American flag … that’s what over 100 years of brand-building will do for you. I am willing to bet that most Americans (and most global inhabitants for that matter) are always a stone’s throw away from an ice cold Coke. Coke has been a favorite of Warren Buffett’s for years. He first purchased $1 billion worth of Coke stock in 1988 and infamously drinks Cherry Coke hand over fist. We can see from the table that Coke consistently hovers around a 30% ROE and has averaged 32%. Not too shabby … it sure beats the Hamburgler. (of course, it still can’t hold a candle to the Colonel.)
Wal-Mart: Whether you love the box store or hate it, this bargain barn has generated a healthy 21% return on equity over the past 10 years … nothing to bat a plastic, whisk broom at either. This company over the years has delivered on a consistent 20% return on equity with the reliability of Old Faithful. Time and again, Wal-Mart has proven its ability to generate a healthy return on equity.
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