Some things to consider.

After Return on Equity

Corporate America periodically goes through revolutions in how companies are managed, how they scale, and how they think about what they do. One of them, which had a permanent impact, was the rise of return on equity calculations. It's an intuitive calculation: divide profits by net worth and you have a measure of how much value that company adds to assets that, in principle, anyone else could have bought at the same price. A big company can always get bigger by continuously reinvesting money, but if its return on equity declines, then investors can look at the marginal return on equity—e.g. a company earned a 10% return on equity last year, reinvested all of that money, and achieved a 9.5% return on its new equity, so the return on the incremental dollar invested in that business was just 4.5%, and shareholders would have been better-off with a dividend or buyback.^[1]

Focusing on ROE makes sense in a world where companies' foremost responsibility is to produce returns for their shareholders. In that model, the company is a legal device for pooling money that's actually owned by shareholders, and ought to return it to those shareholders if it can't use it well. If those managers weren't up to the task, a private equity firm might be happy to lend a hand, selling off the assets that weren't producing much of a return and keeping the ones that were. Return on equity even has some social utility: if capital is scarce, then it's important for it to be invested somewhere that produces a return, and this also solves the company's own capital-scarcity problem by giving them future cash flows they can use to invest for growth.

There are a few standard attacks on return on equity thinking, all of which have some merit as either a reason not to rely on ROE as an analytical tool or to actively discourage companies from tracking it:

1. It ignores intangible assets, so it gives some companies too much credit—marketing is generally expensed rather than capitalized, but a brand is a durable asset that's at least partly built from advertising.^[2]
2. For industries with a high failure rate, any one company's return on equity understates the aggregate that the industry can achieve. Suppose the biotech sector earns average returns on equity of 10%, but that consists of a 90% chance of zero returns offset by a handful of successes. Getting a drug approved isn't entirely a matter of luck, but even if the subsequent probability of success is 15 or 20%, the return on equity will go down.
3. If a company's assets produce a stream of returns that can be used to back a BBB-or-better bond rating, i.e. if investors think it's highly likely that the assets will earn more than 5.5% no matter what happens, then the company that owns those assets may well borrow against them and buy back stock, wiping out the business's equity in an accounting sense. Transdigm, for example, has a negative $20bn book value. Apple isn't quite that extreme, but technically trades at over 60x book value, more than 100% of which is their cash on hand. Obviously if their 150%+ ROE represented a marginal return, they wouldn't be buying back so much stock.
4. A focus on ROE encourages companies to divest capital-intensive assets and to focus on capital-light parts of their business. On a like-for-like basis, that's exactly the right call; if your restaurant business earns a 25% return on equity for some locations and a 5% return for others (and these locations are of comparable maturity, in locations with similar growth prospects, etc.), it's a good idea to liquidate and redeploy. On a national level, the rise of return-on-equity thought coincided with the relative decline of domestic manufacturing: Google's n-gram viewer sees ROE inflecting in popularity in the late 60s, and peaking in the mid-80s, while US manufacturing employment reached an all-time high in 1979, and has almost always had a cyclical peak below the previous one since then. (Though note that there is an exception: peak manufacturing employment in late 2022 was slightly higher than the pre-Covid high.)

There's something else to add to this: for a company that isn't returning much capital, a high return on equity can be a sign of capital misallocation. Here's Walmart's annual report from 1980 (link goes to a page with ten years of financial history). They were consistently achieving returns on equity in the 30-40% range, most of which went back into the business.^[3] They paid a dividend, but retained ~90% of earnings. Shares outstanding compounded in the low single digits over this period, and they didn't use much debt. So for Walmart in the 1970s, return on equity set the speed limit on growth.

A company with that kind of growth profile today won't be funding growth primarily from its own operations, and it wouldn't want to be in a position where, four times a year, it explained in great detail with lots of granular statistics that deep-discount retail in small markets coupled with a highly automated logistics system was a great business. For modern companies with these economics, the plan is to raise private capital and the goal is to spend for growth as fast as possible until the market is saturated.

There's a lot that can go wrong operationally or culturally when this happens, which sets a speed limit on growth. But, importantly, these constraints have both been relaxed, for loosely-related reasons:

1. On the operational side, there are many more business processes that can be represented in and managed by software, which has already been built and tends to have integrations with other useful software. There's a more liquid market in general for services, and some of the data Walmart collected by hand is now aggregated online: Sam Walton used to spend some of his weekends visiting competitors' stores to see what they were selling and how it was moving, and he'd also sometimes take aimless flights past various small towns looking for good prospective locations. A 2024 Walmart can buy much of this data, and, while it's hard to fault Walton's business acumen, can analyze more data and more precisely rank the best opportunities. As a general rule, economic growth is partly a process of taking what used to be a competitive advantage within one company and turning it into a commodity—which means that the companies that do find a comparative advantage can focus more on that.
2. On the cultural side, there are more people who've worked at high-growth institutions, more investors who have a whole portfolio full of such companies, more written material on what it's like and what goes wrong, etc. Early Walmart did take advantage of the inefficient talent market, but any time your company is winning, you want every market to be efficient except the one where yours has an advantage. So this hypothetical hypergrowth Walmart would be spending a lot on LinkedIn, Indeed, and recruiters, and would be less constrained by the difficulty of hiring good managers.^[4]

That decade of Walmart financial statements shows some deceleration; Walmart's return on equity went from over 50% at the start of the 70s to just over 30% entering the 80s. There were plenty of Walmart-worthy small towns at the start of that period, and by the end the best prospects already had a Walmart. It's natural for companies to pick the low-hanging fruit first, and then to move on to the rest, or to build out their core business and then figure out what the right adjacent products are (for Walmart, those expansions have included grocery, white label products, e-commerce, a membership program, and advertising). Some of these businesses have a lower return on investment than the core company, but they have a higher return than the overall company's cost of capital. So they're a good use of shareholder funds even though they optically make the return on equity lower. They also have an effect of making the rest of the company’s return on equity more durable.

In fact, this example is not entirely hypothetical. The blitzscaling edition of Walmart is Amazon, which also aimed to scale up a business with the value prop that it was almost always the fastest and cheapest way to get something.^[5] Walmart was always profitable, and Amazon lost money early on, but over time they converged a surprising amount. Their revenues are within 10% of each other, and, coincidentally, their returns on equity over the last four quarters are within eight basis points. Amazon burned more capital upfront to get there, but it was also operating in an environment where other companies scaled faster. Amazon has a different mix of businesses from Walmart, but Fulfillment by Walmart and Sam's Discount Cloud Computing Club were both constrained by the available technologies and the transaction cost of finding customers.

Equity is just another financial instrument. It's just another way to raise funds, and the real goal of a company is to maximize the present value of the dollars it earns above its cost of capital. A high return on equity is still impressive in isolation, but the question for any 30%+ROE company is why it isn't expanding into all the adjacent businesses with a 25% return, and then moving down from there. Some companies got lucky, and some were lazy. And in a competitive economic environment, lazy doesn't last.

Disclosure: Long AMZN.

1. Why wasn't this always intuitive? One reason is that before the rise of higher retained earnings from the 1920s onward, companies tended to go public at $100/share, pay out most of their earnings as a dividend over time, and have a price that bounced around that $100/share midpoint. Sometimes, a company would turn out to own some asset that gave them unique pricing power, but investors didn't tend to assume that they could reinvest at that rate. When companies started to retain earnings for growth, there was an incentive among bad managers to downplay the return they were getting on new investments, so they wouldn't get fired. And there was an incentive for the top-performing companies to understate this, too, so they could avoid competition. Conglomerates, in particular, had an incentive to downplay return on equity calculations. They could produce growth in earnings per share by using their highly-valued stock as acquisition currency, but that trade looked best when they were acquiring companies that the market wasn't enthused about, which often meant asset-heavy businesses. ↩︎
2. In the long run, brand value is more a function of product quality and customer service, but one way to look at the brand-vs-ad function is to imagine that the brand is an intangible factory that's very efficient at taking inputs like incremental marketing dollars and turning them into the output of higher sales. A manufacturer's return on equity would also look a lot better if their factory and its equipment weren't on the balance sheet. ↩︎
3. Note that one element of this is high interest rates, which reduced the upfront cost of some of the real estate and other assets they were buying in order to expand. Still amazing results, but results that need to be graded on a curve in comparison to modern companies. ↩︎
4. In this example, they would need to change some things about the business. Made in America mentions Walton's pride in how many employees worked their way up from entry-level, and made a boatload on their employee stock. At 30% growth, even with zero attrition your headcount almost quadruples within five years, so there's room to promote internally. At sufficiently fast growth, there isn't enough time to carefully vet someone in one role before they need to take on more responsibilities. But the risk of occasionally promoting the wrong person, or making an external management hire who gets rejected by the company's immune system, is implicitly one of those costs that investors are willing to pay when they underwrite rapid growth. ↩︎
5. The other day, my eight-year-old asked why Amazon ships charging cables so fast compared to toys; the cables sometimes show up the next morning after being ordered the night before. And the reason is that every time Amazon ships them a little faster, it's chipping away at the foot traffic of competing stores, and it's Amazon, rather than Best Buy or Walmart or Target, that gets both the additional purchases added to that shopping cart and the mildly higher future probability that the customer's shopping experience starts and ends on their platform. ↩︎

Absolutely spot-on @Mujo! A great article and well worth the read!

Good post @Mujo

For my part Ive been tracking Incremental ROE and ROC to get a better understanding on the effectiveness of capital allocation

I find you need to do this over a rolling 3 year period to allow for time to see the return from the deployed capital

Thanks for sharing @Mujo -- and definitely like your approach @shearman. One year periods are way too short to judge most capital allocation decisions.