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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 213648  
Subject: Re: Influence on ROE in Investing returns Date: 10/9/2012 4:45 PM
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US inflation in the last 100 years has averaged a little under 3.5%
6.5% + 3.5% = 10%.
This would suggest then that a company deploying capital is destroying value on average if their ROE is less than 10%.


No.
You don't have to do an inflation adjustment on an instantaneous earnings-related rate.
A firm with 10% ROE is likely to have 10% ROE the next year with smaller dollars.
With a shrunken yardstick you get bigger R and proportionally bigger E as well: the same ratio.

For example, an earnings yield doesn't have to be inflation adjusted.
Other things being equal the earnings yield won't change with inflation.
Most firms will on average be able to increase prices to compensate
for their increased costs. This is only an average—some firms
will be hurt by inflation and others will benefit, but it's the general rule.
Also, occasional very high inflation will break the economy which is a separate problem.
But in all but exceptional circumstances inflation can be ignored when looking at earnings yields (and ROE).
It's borne out empirically too. The best fit model of rolling-decade
historical US nominal earnings growth includes the term 0.94 times inflation.

ROE over 15% might be a sensible target because it will limit you
to the better businesses, but it's not needed due to an inflation expectation.
On average since 1997 cutoff that would correspond to 38% of the
average 1584 companies covered by Value Line with the ROE field populated.
You could probably even crank it up a bit and not miss many great firms.
20% would give you 20% of firms. Let's call it the 20:20 rule!

Jim
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