If I had a magical process for investing capital at a high rate of return, let’s say at 20 percent, and you invest $5 with me, at the end of the year I will have made you $1.
You will now be faced with three options:
1. You can take the $1, in which case you can spend it or invest it elsewhere, perhaps in a llama farm.
2. You can leave the $1 with me and allow me to reinvest it for you.
3. Or together, we can use the $1 to buy out existing shareholders.
The first question that should come to mind, if you leave the money with me to reinvest, is “are our children learning,” and next, “Will I have the ability to continue generating the 20 percent rate of return?” Then, if you take the $1, what rate of return can you expect to achieve … in the llama farm? The answer to the first question is found in two components:
1. The track record of ROE in my business.
2. The historic retained earnings off of my business’s balance sheet.
If historically, my business has retained earnings and the ROE has remained strong, averaging 20 percent, then by all appearances the business has the ability to put the $1 to good use, reinvesting it at the high rates of return on equity. If, on the other hand, my business has historically retained earnings (plowed them back into the business for expansion, new business projects, and so on), yet the return on equity has steadily dropped over the years, then it appears that I have poorly allocated retained earnings into low returning investments, and I do not have the capability to effectively expand the business or, at the very least, the core, original business has begun to suck wind. Either way, you will see this as a drop in ROE and perhaps a paltry, anemic ROE track record.
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