Buffett — ROE, ROIC, the dollar test and owner earnings

Return on equity, sustained

ROE = net income ÷ shareholders' equity, and Buffett's interest is in the consistency of it rather than any single year. A business earning above roughly 15% year after year is doing something competitors have not copied.

The trap is leverage. Equity is the denominator, so a company can raise ROE simply by borrowing and buying back stock. High ROE with high debt is a different animal from high ROE without it, which is why the next measure exists.

Return on invested capital

ROIC = EBIT ÷ (equity + debt − cash) puts borrowed money back into the denominator, so financing choices stop flattering the answer. A sustained ROIC above about 12% is the quantitative shadow of what Buffett describes qualitatively as a moat: if returns on capital stay high for a decade, something is stopping competitors from bidding them away.

The dollar test

From the 1984 letter: for every dollar of earnings a company retains rather than pays out, it should create at least a dollar of market value.

Dollar test = change in market cap over 10 years ÷ change in retained earnings over the same 10 years

Pythia measures it across eleven consecutive fiscal years — a true ten-year span — and refuses to compute it on less. A ratio at or above 1.0 passes. Below 1.0 says management would have served owners better by posting them a cheque. It is the sharpest question you can ask about capital allocation, and it is one of the few tests that judges management rather than the business. A company whose retained earnings fell over the window (heavy buybacks and dividends can do this) gets no ratio at all — the test only applies where earnings were actually retained.

It is also the one measure here with a market price on one side, so it inherits the market's mood over the window. Read it over ten years, never over one.

Owner earnings

Buffett's 1986 appendix proposed a substitute for reported profit:

Owner earnings = net income + depreciation and amortisation − maintenance capital expenditure

The intent is the cash an owner could take out each year without the business shrinking. The difficulty is in the last term: filings report total capex, not the split between keeping the lights on and expanding. Buffett acknowledged the number therefore requires judgement.

Pythia approximates it where the legs exist and labels the approximation rather than presenting it as a reported figure. A number that depends on an unreported split should say so.