In the quest for exceptional investments, one metric stands out as both a guiding light and a rigorous filter: Return on Equity (ROE). However, while ROE is essential, it alone doesn’t tell the full story. The interplay between ROE, earnings growth, and revenue dynamics reveals the true quality of a business—and its potential as a great compounder.
This post explores six scenarios of ROE and revenue/earnings dynamics, ranked from the most desirable to the least ideal. Each scenario provides insights into how businesses operate, reinvest, and create value, helping investors identify true wealth compounding machines.
1. Aligned Compounders
Why It’s Ideal:
This dynamic represents the holy grail of investing: sustained ROE paired with proportional growth in earnings and equity. The compounding flywheel is intact, ensuring exponential value creation.
Characteristics:
- Consistent ROE (15-20%).
- Earnings growth aligns with or exceeds ROE.
- Reinvested earnings create a self-reinforcing compounding flywheel.
| Year | Revenue ($) | Equity ($) | Earnings ($) | ROE (%) |
|---|---|---|---|---|
| 1 | 100 | 100 | 15 | 15 |
| 2 | 115 | 115 | 17.25 | 15 |
| 3 | 132.25 | 132.25 | 19.84 | 15 |
| 4 | 152.09 | 152.09 | 22.81 | 15 |
| 5 | 174.91 | 174.91 | 26.24 | 15 |
Example Company: Costco Wholesale (COST)
2. Efficient Compounders (Sustaining Innovators)
Why It’s Strong:
These businesses have high metrics and durable competitive advantages but have matured beyond their explosive growth phase. While they’re not as dynamic as aligned compounders, their focus on efficiency and stability makes them reliable long-term wealth creators.
Characteristics:
- High ROE (20% or more).
- Slower growth (e.g., 3-5%), reflecting a mature phase.
- Focus on efficient reinvestment and shareholder returns (dividends, buybacks).
| Year | Revenue ($) | Equity ($) | Earnings ($) | ROE (%) |
|---|---|---|---|---|
| 1 | 100 | 100 | 20 | 20 |
| 2 | 105 | 110 | 22 | 20 |
| 3 | 110.25 | 121 | 24.2 | 20 |
| 4 | 115.76 | 133.1 | 26.62 | 20 |
| 5 | 121.55 | 146.41 | 29.28 | 20 |
Example Company: The Coca-Cola Company (KO)
3. Efficiency Maximizers
Why It’s Limited:
Earnings growth through efficiency gains is finite. Without revenue growth, these businesses eventually plateau, making them less reliable for long-term compounding.
Characteristics:
- Flat or declining revenue.
- Earnings growth through cost-cutting or margin improvement.
- ROE remains stable but dependent on operational efficiency.
| Year | Revenue ($) | Equity ($) | Earnings ($) | ROE (%) |
|---|---|---|---|---|
| 1 | 100 | 100 | 15 | 15 |
| 2 | 100 | 115 | 17.25 | 15 |
| 3 | 100 | 132.25 | 19.84 | 15 |
| 4 | 100 | 152.09 | 22.81 | 15 |
| 5 | 100 | 174.91 | 26.24 | 15 |
Example Company: 3M Company (MMM)
4. Declining Growth Giants
Why It’s Less Ideal:
As growth slows, the compounding engine weakens. While these businesses may still deliver value, their declining ROE signals diminishing reinvestment efficiency.
Characteristics:
- High initial ROE but declining earnings growth.
- Equity grows faster than earnings, leading to a gradual decline in ROE.
| Year | Revenue ($) | Equity ($) | Earnings ($) | ROE (%) |
|---|---|---|---|---|
| 1 | 100 | 100 | 20 | 20 |
| 2 | 105 | 115 | 22 | 19 |
| 3 | 110 | 130 | 23 | 17.7 |
| 4 | 115 | 145 | 24 | 16.6 |
| 5 | 120 | 160 | 24 | 15.0 |
Example Company: IBM Corporation (IBM)
5. Revenue Chasers
Why It’s Problematic:
Revenue growth without earnings growth erodes efficiency. These businesses often signal poor cost control or reinvestment outside their competitive advantage.
Characteristics:
- Revenue grows, but earnings remain flat or decline.
- ROE deteriorates as equity grows faster than earnings.
| Year | Revenue ($) | Equity ($) | Earnings ($) | ROE (%) |
|---|---|---|---|---|
| 1 | 100 | 100 | 15 | 15 |
| 2 | 110 | 115 | 15 | 13 |
| 3 | 121 | 132.25 | 15 | 11.3 |
| 4 | 133.1 | 152.09 | 15 | 9.9 |
| 5 | 146.41 | 174.91 | 15 | 8.6 |
Example Company: Uber Technologies, Inc. (UBER)
6. Inefficient Allocators (Least Ideal)
Why It’s Unattractive:
These businesses squander their potential by reinvesting outside their core advantages or failing to allocate capital effectively. Over time, their ability to compound erodes.
Characteristics:
- Earnings growth is slower than ROE.
- Poor capital allocation leads to declining efficiency over time.
| Year | Revenue ($) | Equity ($) | Earnings ($) | ROE (%) |
|---|---|---|---|---|
| 1 | 100 | 100 | 15 | 15 |
| 2 | 105 | 115 | 16.5 | 14.3 |
| 3 | 110 | 130 | 17 | 13.1 |
| 4 | 115 | 145 | 17.5 | 12.1 |
| 5 | 120 | 160 | 18 | 11.2 |
Example Company: General Electric Company (GE)
Final Thoughts
Aligned compounders and efficient compounders represent the gold standard for long-term investors, offering sustainable growth and predictable returns. The other categories serve as cautionary tales, highlighting the importance of revenue, earnings, and ROE alignment. By understanding these dynamics, investors can better identify businesses that truly compound wealth over time.