During his recent interview with Tobias, Eddy Elfenbein, who owns the popular investing blog Crossing Wall Street Blog, discusses the most important metrics that investors should consider when determining what a business is worth. Here’s an excerpt from the interview:
Tobias Carlisle: One of the more popular posts on your blog is Why Return on Equity Is So Important. I have some views on equity, but I’d like to hear, why is return on equity so important?
Eddy Elfenbein: Yeah. Let me preface by saying there are problems with all financial metrics, and just be aware of them. But I was trying to say investors always want to run after something at the detriment of all others. I said return on equity is a fascinating, it’s sort of the gold standard of financial metrics, because you’re getting the most pure, three lumps go in, two lumps come out. Per unit of X, what kind of return are you getting? And that is really the essence of finance. You want to look at the efficiency in its purest form. Now again, there can be problems. Let’s say you have real estate on the books that’s not properly valued. Well, that can completely throw it off. Let’s say you invest in a minority stake in a company, and that stock goes through the roof, well that’s going to increase your equity base. Or in a certain year, you’re going to have a tax benefit or a tax penalty.
Eddy Elfenbein: All those things are going to distort your return on equity. Inflationary periods will distort your inventory. Disinflationary will have an impact on well. But the idea, the thinking of return on equity, it focuses the mind of investors, saying this is how much I’m putting in, this is how much I’m getting out. In many ways, people understand bonds, because it has yield to maturity. I think of, try to put your stock into a yield to maturity. Again, it’s a intellectual exercise, but I like doing that, because again, it’s telling investors. I’ve worked at a retail brokerage, and people say, “I want something around $20, $25 per share.” Get away from that kind of thinking. There’s a company behind that share price. Find out what they’re doing. Find out what they’re about.
Tobias Carlisle: I agree with you that return on equity is the singular measure for determining the quality or the worth of the business that you’re looking for. And I always say that cashflow return on invested capital is the only metric that you should be using. But if you are going to use that metric, the very next step, the immediate step after that, you have to work out how sustainable that return on equity is.
Eddy Elfenbein: Absolutely. Absolutely. That’s why-
Tobias Carlisle: And that’s… sorry.
Eddy Elfenbein: You’re exactly right. Also, I believe I have a post on this, that a lot of studies have shown that enterprise value divided by EBITDA… or I have that backwards… that’s been the best measurement. But I wouldn’t get bogged down by the differences. They’re all sort of getting at the same thing. As far as sustainability, it’s exactly right, and that’s why a lot of the companies I go for on the Buy List are sort of these tried and true. You know, Hershey is on there. I feel pretty confident. There’s a company called Hershey, Pennsylvania. There’s no company in America that’s keto or low sugar. There’s no company town named after that. But there is a Hershey, Pennsylvania. You realize that chocolate will be around.
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