Warren Buffett has often emphasised the importance of Return on Equity (ROE). In his most recent letter Buffett lays out ROE as a key criterion for an acquisition by Berkshire:
"Businesses earning good returns on equity while employing little or no debt". – are a Buffett criteria.
In this article, we reveal two large cap, debt free businesses that the Oracle of Omaha might approve.
A Quick Primer on ROE
Calculating ROE is straightforward. It's just the net income expressed as a percentage of shareholders' equity. ROE measures how much income a firm is able to generate from the capital invested by shareholders. According to Buffett, ROE is an effective measure of management's economic performance.
You would have noticed that Buffett cautions us about debt. That's because debt can be used to goose up returns and heavy debt burdens have felled many businesses!
Platinum Investment Management Limited (ASX: PTM)
This is an Australia-based fund manager that specialises in international equities. Asset managers earn fees that are a percentage of total funds under management (FUM), so we should watch FUM and its growth. In FY15, average FUM levels increased by 17.3% to $27 billion.
Platinum has a $4.4 billion market cap, and its shares are trading for 20x trailing earnings. The trailing yield (excluding last year's special dividend) is 4.9%, fully franked. Platinum has averaged 54% ROE during the past five years.
REA Group Limited (ASX: REA)
REA Group is a specialist advertising business that's perhaps best known for its hugely popular property websites, realestate.com.au and realcommercial.com.au. The group also operates leading European property portals casa.it, atHome.lu and immoRegion.fr, and Chinese property site myfun.com.
Recently, REA Group proposed buying the 79.1% of iProperty Group (ASX:IPP) it didn't already own. If this acquisition comes to fruition, REA Group will attain a leading position in the fast-growing property markets of Hong Kong, Indonesia, Malaysia, and Thailand.
REA Group has a market cap of $6.4 billion, and is trading for 32x trailing earnings. The trailing yield is 1.5%, fully franked. Over the past five years, REA Group's average ROE is 40.6%.
Foolish takeaway
You might find the next hot stock tip exciting, but your portfolio's returns are likely better served by strong businesses that can deliver superior returns on capital employed. Consider adding Platinum Investment Management Limited and REA Group Limited to your watch list.
