Credit: Shutterstock photoWhen Warren Buffett is looking for strong companies to invest in, he employs both qualitative and quantitative tests to find the best candidates. Durable competitive advantage and strong management are among the key qualitative measures, and a go-to quantitative metric in the Oracle's arsenal is return-on-equity.
The formula for ROE is simple-net income divided by shareholder's equity (total assets minus total liabilities)-and tells an investor how much cash a company is generating from its existing base of assets. For example, if the ROE is 15%, then 15 cents of assets are created for every dollar originally invested. A steadily increasing ROE is a clue that management is putting its investors' capital to good use.
One Forbes columnist characterizes ROE as "a speed limit on a firm's growth rate" because a company can't grow its earnings at a rate above its ROE without borrowing funds or selling more shares. In a 2007 paper that addresses the measurement and implications of ROE, NYU Professor of Finance Aswath Damodaran writes, "We can safely conclude that the key number in a valuation is not the cost of capital that we assign a firm but the return earned on capital that we attribute to it." Note: Return-on-capital includes debt as well as equity in the calculation.
Buffett looks for companies with ROE of above 15 percent in each of the past ten years. He sees this as an indication that management has done a good job allocating retained earnings for the benefit of the shareholders. He doesn't stop there, however. Because some companies can be financed with debt that far exceeds equity, they can also show a consistently high ROE yet still be unattractive from a valuation standpoint. So, Buffett also requires 10-year average return-on-total capital, which includes both equity and debt, to be at least 12 percent.
From an investor's standpoint, an attractive stock will offer a high ROE as well as a favorable dividend yield (annual dividends-per-share divided by price-per-share), which measures how much cash flow an investor is getting for each dollar invested-the "bang for your buck". Economist and quant investor James O'Shaughnessy, a guru that inspired one of my stock screening models, viewed dividend yield as an essential metric when evaluating large companies. He found that market-leaders with high dividends tended to outperform during bull markets and didn't fall as far as other stocks during bear markets. He also found that high dividend payouts were a good predictor of success for this group of companies. John Neff, a bargain-hunting guru who managed the Windsor fund for over 30 years, also focused his attention on dividends. He argued that while stock prices are subject to the whims of the market, solid companies rarely cut their dividends.
Using my stock screening model inspired by the investment philosophy of Warren Buffett, I have identified the following four high-scoring stocks based on ROE and dividend yield:
Taiwan Semiconductor ( TSM ) is a manufacturer and seller of integrated circuits and semiconductors and earns high marks from our Warren Buffett-based stock screening model due to its earnings predictability and ability to pay off its debt ($4.79 billion) with earnings ($9.69 billion) within two years. Average return-on-equity over the past ten years of 21.2% well exceeds the preferred range of 15%. Free cash flow-per-share of $0.92 indicates that the company is generating more cash than it is consuming, a plus under this strategy, and management's use of retained earnings reflects a favorable return of 59.7%. TSM also earns a high score from our Peter Lynch-based investment methodology due to its ratio of price-earnings to growth in earnings-per-share (PEG ratio) of 0.69 (required to be under 1.0 to pass). Total debt-equity is favorable at 17.76%.
VF Corp. (VF) is engaged in the design, manufacture, marketing and distribution of branded lifestyle apparel, footwear and related products. The company passes our Buffett-inspired stock screening model due to its stable and expanding earnings-per-share and its ability to pay off debt ($2.34 billion) with earnings ($1.20 billion) within two years. Average return-on-equity for the past ten years of 17.7% exceeds the 15% minimum requirement, as does the same ratio for the past three years (which averaged 20.2%). Shares outstanding have decreased over the past five years, indicating that management has been using excess capital to increase shareholder value-a plus under this model.
Paychex, Inc. ( PAYX ) is a provider of integrated human capital management ( HCM ) solutions for payroll, human resource, retirement and insurance services for small- to medium-sized businesses in the U.S. Our Buffett-inspired stock screen likes the company's earnings predictability and its consistently higher-than-average return-on-total capital over the past ten years of 36% (compared to the minimum requirement of 12%). Management's use of retained earnings reflects a return of 24.7%, favored under this strategy, and the debt-free balance sheets adds appeal.
Telstra Corp. Ltd. ( TLSYY ) is a telecommunications and technology company that gets a thumb's up from our Buffett-based screen for its earnings predictability and favorable average return-on-equity of 29.0% over the past ten years (versus the minimum requirement of 15%), a level which has been maintained over the past three years as well. Management's use of retained earnings reflects a return of 19.4%, which adds appeal.
At the time of publication, John Reese and his clients were long TSM, VF, PAYX and TLSYY
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
