Why is Return on Equity (ROE) considered a more important metric than Earnings Per Share (EPS) growth?

Why Is Return on Equity (ROE) Considered a More Important Metric Than Earnings Per Share (EPS) Growth?

In investment analysis, particularly based on Warren Buffett's perspective in his letters to shareholders, Return on Equity (ROE) is regarded as a core indicator for assessing a company's intrinsic value and long-term profitability. While Earnings Per Share (EPS) growth is commonly used, it is often less reliable than ROE. Key reasons include:

1. ROE Reflects Capital Efficiency

• ROE is calculated as: ROE = Net Income / Shareholders' Equity. It measures how much profit a company generates per unit of shareholder equity, reflecting management’s efficiency in utilizing capital.
• Buffett emphasizes that a high ROE indicates a company can efficiently reinvest retained earnings to create more value. For example, if a company consistently maintains an ROE above 15% and achieves growth without significant additional capital, this often signals a sustainable competitive advantage (e.g., an "economic moat").
• In contrast, EPS growth (EPS = Net Income / Shares Outstanding) can be artificially inflated through stock buybacks, increased debt, or equity dilution, which may not reflect genuine profitability.

2. EPS Growth Is Easily Manipulated and Unsustainable

• EPS can be boosted by short-term factors, such as one-time gains, accounting adjustments, or debt-fueled expansion. Even with strong EPS growth, a low ROE suggests reliance on external funding or inefficient operations, potentially destroying long-term value.
• Buffett has repeatedly noted that many companies achieve EPS growth through acquisitions or high debt, but this often dilutes returns on equity, creating an "illusion of growth." For instance, a company may raise EPS by issuing new shares to acquire assets, but if the acquired assets have low ROE, overall efficiency declines.

3. ROE Focuses on Long-Term Value Creation

• Buffett views ROE as key to evaluating "intrinsic value" because it directly links to the compounding effect. Companies with high ROE can retain and reinvest profits efficiently, creating a "snowball effect" that drives long-term shareholder wealth.
• EPS growth, however, emphasizes short-term performance and is more susceptible to market volatility and cyclical factors. Buffett advises investors to prioritize companies with consistently high ROE (e.g., Coca-Cola or Gillette), which stand out in his portfolio.

4. Case Studies and Investment Implications

• In his letters, Buffett frequently compares Berkshire Hathaway’s ROE to the S&P 500’s performance, underscoring ROE as a criterion for long-term holdings.
• Investors should prioritize stocks with ROE > 15% (industry-adjusted) and stable trends, rather than chasing EPS growth alone. This helps avoid "value traps," such as cyclical stocks with high EPS growth but low ROE.

In summary, ROE better reveals a company’s core competitiveness and management quality, while EPS growth is often superficial. Buffett’s core investment philosophy is clear: seek exceptional businesses that consistently create value through high ROE—a priority far exceeding short-term EPS fluctuations.