Effective Business Valuation 121understanding of this concept helped create one of the world ’ s
most successful companies.Understanding Return on Equity:
Microsoft Corporation
While profi ts are essential, understanding how they fi t into the
value creation process is critical. This is where return on equity
comes into play.
An initial yet meaningful way of looking at return on equity is
similar to a coupon on a bond. A bond that earns a higher coupon
yield than the prevailing rate of interest will trade at a premium, or
above its par issued price. A bond that is issued paying 10 percent a
year will be worth more in the future if future rates on interest have
declined. The reason is simple economics: No investors will pay the
same price for an 8 percent bond if they can buy a 10 percent bond
for the same price. So the price of the existing 10 percent bonds
will increase until the new market price represents an approximate
8 percent effective yield. If the bond had a face value of $ 1,000 and
initially paid $ 100 a year, its new price would be $ 1,250 because
at an annual payment of $ 100, the return is 8 percent. Similar to
a bond in a fundamental sense, businesses with sustained high
returns on equity usually are followed by appreciating stock prices,
but not for the same specifi c reasons as bonds. In the real world, of
course, investors in stocks don ’ t just buy and hold. In the long run,
the rate of return of a stock should equal its return on equity.
Consider Microsoft. Microsoft continues to deliver unbelievable
returns on equity of over 40 percent and has done so for decades.
Yet for years, Microsoft shares have not followed suit. The times
are different. In the beginning, Microsoft had lots of space in the
software market to deploy its capital. So when Microsoft was gener-
ating an ROE of, say, 40 percent, it was able to continue investing
that excess capital and generate a similar rate of return. What thisCH006.indd 121CH006.indd 121 9/2/09 6:58:11 PM9/2/09 6:58:11 PM