During our recent rebalancing, we added a new type of investment to the majority of our client portfolios. No, we didn’t add investments made up of lemonade stands. Instead, we added a number of funds comprised solely of businesses with a high return on equity (ROE). So what is return on equity (ROE) and why is it important?
ROE simply measures a business’s profitability by revealing how much profit a company generates with the money invested in the company. Let us explain in an example.
Let’s say you have the option to invest in one of two lemonade stands in your neighborhood. The first lemonade stand sits on the corner of the street and is able to generate $100/year of income. The total amount of investment needed to start and run that lemonade stand was $1,000. The $1,000 included the cost of materials to build the stand, the cost of the lemonade powder, water, cups, ice, etc. So, for this first lemonade stand an investment of $1,000 generates $100/year of income. Well, this lemonade stand has a 10% Return on Equity ($1,000/$100). You divide how much you invested by the amount of total income you are receiving.
Now let’s say a second lemonade stand sits on the opposite corner and also costs $1,000 to start and run. However, this lemonade stand generates $200/year. In this case, you invested the same $1,000 but were able to generate $200/year of income. This is a 20% ROE ($1,000/$200).
If you had to choose, which lemonade stand do you want to own? Of course you would choose #2. The lemonade stand with the higher return on equity (ROE).
The higher the ROE, the more profit the company has to reinvest to further grow, make acquisitions, or buyback stock. However, one, and arguably the most important use of ROE is to take a portion of the earnings and send them to you, the shareholder, as income in the form of a dividend. For those people that are already retired, this helps provide consistent income in an up, down or sideways market. For those that are still in the accumulation stage, this income can be reinvested back into your portfolio.