Price on Value
April, 2002

The One Question You Need To Ask

John Price,  Ph.D.

Your stockbroker calls to recommend that you buy shares in a particular company. Suppose that you can only ask one question, what would it be?

You could try "Am I going to make money from this?" but I think that most people have learned the hard way on this one. The same applies to questions like, "Is it good value?" or "What price do you think it will be next week? Or next month? Or next year?"

What about the question, "Who is recommending these stocks?" This is not much help either. Consider all the analysts and investment writers falling over each other to recommend Amazon.com when it was $113 and Enron when it was $89. Now Amazon.com is $18 and Enron is history.

How about, "What does the company do?" This could be helpful if you happen to know something about the industry, but mostly we will just get a positive answer along the lines that this is the industry of the future, about to take off, and so on.

Or you could ask about earnings of the company and how fast they are growing, or are expected to grow. Now you are starting to get somewhere. In my workshops I like to get people to think of earnings per share as the money that the company is making on their behalf for each share that they own. The earnings of a company are the gross revenues or sales less all expenses and taxes. Earnings per share is this figure divided by the number of outstanding shares.

At the very least this would stop you ending up with a large number of flops such as eToys, Webvan Group Inc., Winstar Communications Inc and a whole range of internet companies. At the time of their maximum visibility they didn't have any earnings and were not anticipated to have much, if any, in the foreseeable future.

Another question is what is the company's price to earnings ratio or PE ratio? This is the ratio of the share price divided by the earnings per share. It could be of some help, but it is limited.

Some people focus on stocks that have high PE ratios. These people are often referred to as growth investors. Others focus on stocks that have low PE ratios and are referred to as value investors. The notion of growth and value investing comes from the idea that if a company has a high PE ratio, it is because the market believes that it is likely to have a high growth rate of earnings. In contrast, if it has a low PE ratio, some investors believe that it is more likely to have undiscovered value.

However, the division between growth investing and value investing, and hence between high and low PE companies, is artificial. Every investor is interested in value no matter whether it is among high PE, medium PE or low PE companies. Bed, Bath and Beyond has a PE ratio of 48, Pier 1 Imports 22.8 and Kmart 9.9. Just by looking at the PE ratio, there is no clear reason why you would choose one company over the other two.

Although some of the above questions might be helpful, on their own they will not enable you to weed out the also-rans and leave you with the best investments. If I had the chance to ask only one question, it would be, "How well is management doing with the money that they have?" Or, to put it more personally, how well would they have done with my money if I had been an investor in the company? This won't tell me how well they will do with it in the future, but if they have consistently had superior performance in the past, then I am interested in looking at them more closely.

The simplest measure of the money that management have in the business is equity. This is the assets of the company minus all the liabilities. In other words, the money that would be left if the company was sold and all its debts were paid. (Equity is an accounting concept and the actual amount that would be left could be quite different. Nevertheless, it is a good starting point.)

The profits of the company are the earnings described above. Dividing these profits by the equity is called return on equity, or ROE for short. It is the primary measure of how well management is running the company.

Warren Buffett, the world's most successful investor, turned $100,000 into $45 billion over 45 years through conservative, long-term investing. Each year in the annual report of his company Berkshire Hathaway he gives a list of six criteria that would need to be satisfied by a company before he would consider investing in it. Some of these are not relevant for us such as his preference for large purchases (in the $5-20 billion range!). Others are already satisfied. For example, that management is already in place.

The criterion that is relevant for us is "a businesses earning good returns on equity while employing little or no debt." Statements like this are scattered throughout his writings showing that the level of a company's ROE has been, and continues to be, a corner stone for Buffett's investment decisions.

Recently I examined the performance of the largest 1000 companies. There was a correlation of 40% between their average annual return for the past five years and their ROE. In other words, on average the higher the ROE, the better the investment.

Crunching the numbers another way, the average annual return for the ten companies with the lowest ROE was 5.6% while that for the 10 companies with the highest ROE was 35.8%.

Of course, just because a business has a high ROE, it does not mean that it will stay this way. Also it may be so over-priced that it is better to look elsewhere. Nevertheless, looking at ROE is an excellent place to start searching for those superior investments. So the next time your stockbroker recommends a company, ask what is its return on equity. Let me know what answer you get. I can be contacted at johnp@sherlockinvesting.com.

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Dr Price has developed Valuesoft, a suite of functions for Excel to help find great companies and to calculate what price to pay for them. His website is www.sherlockinvesting.com.