Research Note: The True Performance Measurement Imperative
Words of Wisdom
"True Performance Measurement Requires Adjusting for Capital Growth. Return on equity provides the only honest measure of management's economic performance by comparing earnings to the capital required to generate them, as earnings per share growth can be meaningless when it simply reflects retained earnings being reinvested at mediocre rates. Berkshire's 18.6% return on equity in 1979 demonstrated genuine value creation, while companies boasting "record" EPS growth often produce results no better than a dormant savings account that automatically compounds interest. This insight explains why businesses like See's Candies that generate high returns on incremental capital create far more shareholder value than capital-intensive enterprises showing impressive EPS growth through massive reinvestment at poor returns."
Analysis
The mathematical superiority of ROE-focused analysis becomes evident when examining real-world capital deployment outcomes across different business models and time horizons. As of the second quarter of 2024, the long-term average ROE of the S&P 500 stands at approximately 21.71%, yet this aggregate figure masks dramatic variations in management effectiveness and capital efficiency across individual companies. Consider the stark contrast between asset-light and capital-intensive approaches: See's Candies generated over $2 billion in profits from Berkshire's initial $25 million investment, requiring only an additional $40 million in capital over decades, producing an effective return on incremental capital exceeding 5,000% over the holding period. This performance stands in sharp relief to typical capital-intensive enterprises that may achieve impressive EPS growth of 10-15% annually while requiring proportional increases in invested capital, resulting in ROE metrics that barely exceed risk-free Treasury rates. The deceptive nature of EPS-focused metrics becomes particularly pronounced during inflationary periods, where nominal earnings growth may appear robust while inflation-adjusted returns on equity reveal wealth destruction rather than creation. From 1972 to 2006, See's increased candy prices from $1.8 per pound to $11.6 per pound while expanding production from 16 million to 33 million pounds, demonstrating pricing power that translated directly to ROE expansion. Companies lacking similar competitive advantages typically find their EPS growth constrained by the need to reinvest earnings at returns equal to or below their cost of capital, creating the illusion of progress while failing to generate genuine economic value for shareholders.
The fundamental distinction between growth companies and value-creating enterprises lies in their relationship between earnings growth and capital requirements, with superior businesses demonstrating the ability to generate increasing returns on static or slowly growing capital bases. Warren Buffett specifically noted that wonderful businesses "don't soak up capital and they throw off a lot of cash for their investors," allowing excess capital to be redeployed into other investments without ongoing capital spending requirements. This cash generation capability enables compound returns that far exceed what EPS-focused analysis would suggest, as the freed capital can be invested in additional high-return opportunities rather than being trapped in mediocre reinvestment within the original business. Conversely, capital-intensive enterprises often present management teams with the challenging task of continuously finding profitable uses for retained earnings within their core operations, leading to diminishing returns and ROE compression over time. Analysis shows that high-quality consumer goods companies with high single-digit growth typically trade at P/E ratios exceeding 20-25 times earnings, yet investors paying such multiples for businesses requiring substantial ongoing capital investment frequently achieve returns inferior to those available from simple index fund investing. The persistence of this valuation gap reflects the market's gradual recognition that sustainable competitive advantages and pricing power matter more than absolute growth rates when measuring long-term wealth creation potential. ROE analysis cuts through the noise of accounting-driven metrics to reveal which management teams possess genuine skill in converting shareholder capital into economic value, making it the essential tool for distinguishing between companies that create wealth and those that merely manage assets.
Bottom Line
Investors seeking genuine wealth creation must prioritize Return on Equity over Earnings Per Share growth, as ROE reveals management's true skill in converting shareholder capital into profits while EPS growth often masks value destruction through inefficient capital deployment. Capital-light businesses with high returns on incremental investment consistently outperform capital-intensive enterprises with impressive EPS growth, as demonstrated by See's Candies generating over $2 billion in profits from minimal additional capital versus typical companies requiring proportional capital increases to achieve earnings growth. The mathematical reality demands that sustained ROE above 15-20% creates substantially more shareholder wealth than double-digit EPS growth achieved through massive reinvestment at mediocre returns, making ROE the definitive measure for separating exceptional management from skilled asset accumulators.