Long-Term Investing: Look at ROE or PE?

Many investors have heard the idea that “long-term compounding ≈ ROE.” This concept was first put forward by Charlie Munger, known as the Munger Rule. In his 1981 shareholder letter, Warren Buffett also pointed out that if PE remains unchanged, a company with 14% ROE will generate a long-term investment compound return of 14% as well. He also endorsed the Munger Rule.

Is compounding only about ROE? Or should we be paying more attention to PE? The answer is: both are correct, but from different angles. $Berkshire Hathaway(BRK.B)$

1. ROE: The “Engine” of Internal Compounding

ROE = Net Income ÷ Shareholders’ Equity

A high ROE means the company can efficiently generate returns on equity, which gives it long-term compounding potential.

This is why Buffett prefers consumer and software companies — light-asset businesses with high ROE.

2. PE: The Investor’s “Price Anchor”

PE (Price-to-Earnings Ratio) = Stock Price ÷ EPS

It represents how much investors are willing to pay for every $1 of profit. Lower PE = better entry price.

But looking at just the current PE is not enough, since it is based on the past 12 months of earnings. That’s where Forward PE (Forward Price-to-Earnings Ratio) comes in:

Forward PE = Stock Price ÷ Next 12 Months’ Forecast EPS

Compared to static PE, Forward PE better reflects market expectations for future earnings.

3. Beyond ROE and PE: Other Indicators for Long-Term Investing

To fully understand compounding, investors should also consider these metrics:

ROIC (Return on Invested Capital)

More comprehensive than ROE since it accounts for both equity and debt. A high ROIC means the company is highly efficient at deploying overall capital.

Profit Margin & Growth Rate

Stable margins and consistent revenue growth are the foundation of sustaining ROE. Without growth, it’s hard for ROE to stay high over the long run.

Free Cash Flow (FCF)

Free cash flow shows whether the company generates “real money” to fund expansion and dividends. Over the long term, discounted cash flow remains the core of valuation.

Before investing in Apple, Buffett asked himself three questions that are highly relevant to long-term investors:

1. Within the S&P 500, which companies will trade below 15x PE in the next year?

2. Which companies will earn more over the next 5 years? (with 90% certainty)

3. Which companies can achieve 7% compound growth? (with 50% certainty)

In essence, this combines Forward PE + earnings growth + compounding potential.

Discussion:

When picking stocks for the long run, do you focus more on ROE or PE? Why?

Do you think ROIC and FCF are more important than ROE in compounding?

If you could only choose one metric for a 10-year investment decision, which one would it be?

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