Tuesday, March 10, 2009

Einhorn: Return on Equity

Wide Moat Investing, a blog we've just become aware of (thanks to Simoleon Sense), had an excellent recap of a talk David Einhorn gave at the 2006 Value Investing Congress. The topic was the value of looking at return on equity.
...There Einhorn argued that ROE is only a meaningful metric for capital-intensive businesses—like traditional manufacturing companies, distribution companies, most financial institutions, and retailers (4). For businesses that are not capital intensive—whose profits derive primarily from intellectual capital or human resources (e.g., pharmaceutical companies, software companies, etc.)—it is “irrelevant to worry about ROE” (4).

Why? Because businesses that are not capital intensive do not generate substantial returns from retained earnings or capital expenditures.

For example, if you are an insurance agent, you will bring in much more business and profit by getting on the phone and meeting more potential clients, rather than tripling your office space, or adding that new water feature to the atrium, or buying that highly efficient “document station.”

In short, it’s not the “equity” which provides the retums, but the people, the brand, or the proprietary product—things which don’t show up on the balance sheet. ROE then is insignificant. For the most part.
More analysis at the blog. And, as usual, we recommend reading on. Just a quick comment of my own. What I enjoyed about reading this was seeing how Einhorn once again looks at the value of what others take as "general rules" and places it in the specific context where it is reliable, while noting where it is not.

Readers who want to see another example of Einhorn doing this contextually-based thinking, should read his comments on insider purchases that we blogged about here.