ROE and ROIC in Value Investing

Hello investors!

In today's newsletter, I'm excited to discuss two crucial financial metrics that are instrumental in the world of value investing and several news and interviews as usual.

In todays letter

• Learning: ROE and ROIC in Value Investing

• News insights

  • Burry Bails on Bank Bets Amid Crisis

  • UK Inflation Dips to 6.8%, Rates Still Rising

  • Disney Holds Back Millions from 'Avatar' Financier

• Key takeaways from video about investing traps (Guy Spier)

ROE and ROIC in Value Investing

ROE measures a company's profitability by showing how much profit it generates with the money shareholders have invested. It's calculated by dividing net income by shareholders' equity. Higher ROE values indicate that a company is effectively using its equity to generate profit.

ROIC, on the other hand, takes a broader view by considering both equity and debt financing. It measures how well a company is using its total invested capital (equity and debt) to generate profit. It's calculated by dividing net operating profit after taxes by total invested capital. A high ROIC suggests that a company is generating good returns on all the capital it employs.

Examples of ROE and ROIC

Consider a company, ABC Inc., with a net income of $1 million, shareholders' equity of $5 million, and total invested capital of $8 million. The ROE would be calculated as:

ROE = Net Income / Shareholders' Equity = $1 million / $5 million = 20%

And the ROIC would be:

ROIC = Net Operating Profit After Taxes / Total Invested Capital = $1 million / $8 million = 12.5%

In this example, ABC Inc. is generating a 20% return on its equity and a 12.5% return on its total invested capital.

How to Evaluate and Use ROE and ROIC

1. Compare to Industry Peers: Compare a company's ROE and ROIC to those of its industry peers to understand its relative performance.

2. Consistency Over Time: Look for companies with consistently high ROE and ROIC over time, indicating sustainable profitability.

3. Debt Impact: High ROE can sometimes result from high debt levels, which may increase risk. Evaluate the company's debt-to-equity ratio alongside ROE.

4. Understand the Drivers: Analyze the components of ROE (net profit margin, asset turnover, and financial leverage) to understand what's driving it.

5. Use as a Screening Tool: Use ROE and ROIC as part of a screening process to identify potential investment opportunities.

ROE and ROIC are essential tools in the arsenal of any value investor. They provide insights into a company's ability to generate profits from its equity and overall capital. As the legendary investor Warren Buffett once said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Metrics like ROE and ROIC can help you identify those wonderful companies.

Keep in mind, though, that no single metric can give a complete picture of a company's financial health or potential as an investment. As Buffett's long-time partner, Charlie Munger, often emphasizes, it's important to have a multidisciplinary approach and consider a variety of factors before making investment decisions.

News insights

Burry Bails on Bank Bets Amid Crisis

Michael Burry, the investor famous for shorting subprime mortgages before the 2008 financial crisis, has exited his stakes in six regional banks, according to filings with the SEC. Burry's hedge fund Scion Asset Management sold out of Western Alliance, Huntington Bank, PacWest, and First Republic during the second quarter, following a period of crisis for regional banks, which saw the FDIC seize First Republic and PacWest agree to merge with rival Bank of California.

[📝Full article]

Key takeaway

The decision by Michael Burry to exit his positions in these banks could indicate a lack of confidence in the regional banking sector's near-term prospects. For investors, this may serve as a signal to reassess their exposure to this sector and consider reallocating funds to more promising investment opportunities. As always, investors should conduct thorough research and consider their own risk tolerance before making any investment decisions.

UK Inflation Dips to 6.8%, Rates Still Rising

UK inflation fell sharply in July to a 17-month low of 6.8%, primarily due to lower energy prices, according to official figures. This decline, down from June's 7.9% rate, is welcome news for households struggling with the cost of living crisis, but it is not expected to prevent the Bank of England from raising interest rates again next month, especially as wages are increasing at a record high.

[📝Full article]

Key takeaway

This news means that while the UK inflation rate has decreased, it still remains high, particularly compared to other G-7 nations. Investors should monitor the Bank of England's policy decisions, as further interest rate hikes may affect borrowing costs for consumers and businesses. In light of this, investors may consider adjusting their portfolios to account for the potential impact of higher interest rates on various asset classes.

Disney Holds Back Millions from 'Avatar' Financier

TSG Entertainment, a Hollywood financier, is suing Disney for breach of contract, alleging that Disney and its studio 20th Century Fox withheld profits and manipulated deals to enhance its streaming platforms and stock price. The lawsuit claims that these actions deprived TSG of cash to invest in films and hindered its ability to sell stakes in other movies, with TSG alleging that they have been underpaid by at least $40 million due to "rampant self-dealing" and "accounting tricks."

[📝Full article]

Key takeaway

For investors, this lawsuit may indicate potential legal and financial risks associated with Disney and its acquisition of 20th Century Fox. Investors should closely monitor the developments of this lawsuit, as any outcome could impact Disney's financial performance and reputation in the industry. It is essential for investors to consider how legal issues like this one might affect their investment strategy and to stay informed on the situation as it evolves.

Key takeaways from video about investing traps (Guy Spier)

Here are the first five takeaways from the first segment of the video:

1. The video discusses the recent period of market boom, bubble, and bust, highlighting how even smart and successful fund managers were drawn into investing in seemingly overpriced but high-quality or promising companies. This period was characterized by volatility and uncertainty.

2. The conversation touches on the impact of lockdowns on businesses in the cloud and SaaS sectors. Companies like Zoom experienced soaring share prices as they benefited from the shift to remote work. However, the speaker had historically avoided technology companies, particularly those aggressively spending to capture market share.

3. The speaker recalls a meeting with Eric Schmidt, former CEO of Google, who emphasized the importance of market share and the "land grab" mentality in the tech industry. This approach was seen as a fundamental business rule in the tech world, prompting the speaker to explore these new business models.

4. To remind himself to engage with and understand these new business models, the speaker changed his password to "new economy." He read books and tried to grasp market shifts, such as the rise of Netflix and over-the-top services. However, he found it challenging to reconcile his traditional valuation criteria with the metrics and valuations of these new businesses.

5. The video discusses the difficulties of valuing content companies like Netflix and Disney. These companies invested heavily in content, making it hard to determine how to amortize this content. The speaker also mentions the concept of unit economics, focusing on customer acquisition cost and lifetime customer value. However, he felt uneasy about relying on long-term assumptions in an industry where technology is constantly evolving.

[🎥Full video]

Stay tuned for more insights and strategies in future newsletters as we continue to explore the world of value investing together.