ReTurn On Equity - a Compelling Case for Investors

RETURN ON EQUITY:

A COMPELLING CASE FOR INVESTORS

by Adam Calamar, CFA, Porfolio Manager[pic 2]

WHITE PAPER

Introduction

A Series of Reports on Quality Growth Investing                                                jenseninvestment.com

selecting stocks that can provide

At Jensen Investment Management, we believe that Return on Equity (ROE) is a very useful criterion for identifying companies that have the potential to

provide attractive returns over long periods of time. Our experience and

research suggest that our requirement of consistently high Return on Equity results in a universe of high-quality, profitable companies that are able to

generate returns above their costs of capital in a variety of circumstances and economic environments. Further, we believe that this universe produces

companies with sustainable competitive advantages, strong growth potential and stocks with a lower beta relative to broad market indices. This paper

serves to illustrate the reasons why we use Return on Equity the way we do, and why we use it for the first step of our fundamental investment process.

From the beginning, now more than twenty-five years ago, Return on Equity has been a key component of Jensen’s investment process. We start by annually selecting only those U.S. companies that have earned a Return on Equity of 15% or greater for the last ten consecutive years, as determined by Jensen’s Investment Committee.1   From there, we narrow down this universe of high Return on Equity companies through fundamental research based on their growth potential, financial strength, competitive advantages and their lines of business. Finally, we seek to identify the undervalued securities – those that are the ‘best deals’ of the companies that we follow.

We seek to invest only in quality growth businesses that we can reasonably understand, whose outlooks are favorable and that can be acquired at sensible prices. Our investments remain unless business fundamentals deteriorate below our strict standards, we identify a more compelling opportunity or the stocks become overpriced based on our metrics.

This paper, however, is about Return on Equity, how we use it in the first step of our investment process and why we believe that it can be a very useful criterion for

attractive returns over long periods of time. We will cover the basics of the calculation, why we use a time period of ten consecutive years, and why we use a threshold of 15% per year. Finally, we

will examine the persistence of Return on Equity, as well as a few interesting characteristics of high-ROE companies.

An Overview of Return on

Equity

Return on Equity effectively measures how much profit a company can generate on the equity capital investors have deployed in the business, and can be

used over time to evaluate changes in a company’s financial situation. At Jensen, we calculate ROE as the

company’s annual net income after taxes (excluding non-recurring items), divided by the average shareholder equity. Net Income is the amount of profit that a company has made after all expenses and taxes are deducted from revenues. Shareholder equity is the value that the owners of the company have invested

that has not been paid out in dividends.[pic 3]

[pic 4]

1  For example, this “universe” of companies developed by the Investment Committee may include companies with negative equity that have engaged in large debt-financed share repurchases.

Simply put:

ROE =

Net Income

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Revenues-Expenses-Taxes

Average Shareholder Equity        Average Total Assets - Average Total Liabilities

In other words, Return on Equity indicates the amount of earnings generated by each dollar of equity. It can be a valuable insight into a company’s operations. In general, the higher the ROE the better, as high ROE companies, all other things being equal, will produce more earnings and free cash flow that can be used to support a higher level of growth, keep the company financially strong, and provide cash returns to shareholders.

This concept is shown in the following table (Figure 1) wherein Company A has an ROE of 20% and Company B has an ROE of

10%. Each has a dividend payout ratio of 30%:

Figure 1: The Link Between High ROE and Instrinsic Value*

Time Period

(years)                Item

Initial equity investment

Company A Value ($)

$100.00

Company A Change (%)

Company B Value ($)

$100.00

Company B Change (%)

0                         Net income

Absolute reinvestment**

Ending equity value

1                         Net income

Absolute reinvestment

Ending equity value

2                         Net income

Absolute reinvestment

20.00

14.00

114.00

22.80

15.96

129.96

25.99[pic 7]

18.19

10.00

7.00

14%                           107.00              7%

10.70

7.49

14%                           114.49              7%

11.45

8.01

3                         Ending equity value                                           $148.15             14%                         $122.50              7%

*  This is a hypothetical, simplified example (based on beginning of year equity) and is for illustration purposes only. These figures are not indicative of the actual returns likely to be achieved by an investor.