To The Moon

$S&P 500(.SPX)$

When it comes to building wealth through the stock market, the long-term investor’s most important tool isn’t clever market timing or exotic strategies—it’s the power of compounding. The challenge, however, is in identifying which companies can compound effectively over decades, and at what price they should be purchased.

Two of the most commonly debated metrics among investors are Return on Equity (ROE) and the Price-to-Earnings (PE) ratio. Both hold critical information: ROE speaks to the intrinsic ability of a business to generate profits on shareholder capital, while PE reflects how the market values those earnings. The debate, therefore, is essentially about quality versus price.

In this article, we’ll explore:

1. The logic behind the “Munger Rule” and why compounding ≈ ROE.

2. Why price still matters and how PE can amplify or destroy returns.

3. Why some investors prefer ROIC and Free Cash Flow (FCF) over ROE.

4. Case studies of how these metrics played out in companies like Coca-Cola, Apple, Amazon, and Intel.

5. If forced to choose one metric for a 10-year investment, which should it be?

1. The Munger Rule: Compounding ≈ ROE

Charlie Munger, Warren Buffett’s legendary partner, often emphasized that long-term shareholder returns tend to mirror a company’s ROE, provided valuation multiples stay relatively constant and earnings are reinvested at similar rates.

Here’s the essence of the rule:

• A company with a 14% ROE that retains and reinvests its earnings should compound shareholder wealth at roughly 14% per year over the long term.

• Buffett echoed this in Berkshire Hathaway’s 1981 letter, stating that if a company’s PE multiple remains steady, shareholder returns will closely follow the business’s ROE.

This is why Buffett and Munger have long been obsessed with “compounding machines”—businesses that generate high ROE without needing excessive debt, and that can redeploy capital internally at high rates.

Example: Coca-Cola in the 1980s–1990s

Coca-Cola was a textbook case. From 1988 to 1998, KO maintained ROE above 30% while continuously reinvesting in its global distribution and brand expansion. Investors who bought Coca-Cola in the late 1980s compounded at close to 18% annually over the next decade—not far from its reinvested ROE profile.

This illustrates Munger’s point perfectly: a strong ROE that can be sustained leads to strong long-term returns.

2. The Case for PE: Price Still Matters

While ROE measures business quality, investors must not forget the other half of the equation—price. Even the best compounders can become poor investments if bought at unjustifiable valuations.

Imagine two businesses:

• Company A: ROE of 20%, but trading at 50x earnings.

• Company B: ROE of 12%, trading at 12x earnings.

Over 10 years, Company A’s intrinsic compounding may be stronger, but at such a high multiple, future returns are capped unless growth exceeds lofty expectations. Company B, however, may deliver comparable or superior long-term returns simply because the entry price was low enough to provide a margin of safety.

Example: Cisco in 2000

Cisco was the darling of the dot-com era, boasting an exceptional ROE above 25% and clear dominance in networking. Investors believed it was a “can’t lose” stock. But trading at over 100x earnings in 2000, Cisco was priced for perfection. Even though its business remained profitable, shareholders who bought at that peak are still underwater two decades later.

The lesson? Even a great company at the wrong price can be a terrible investment.

3. Beyond ROE: The Case for ROIC and FCF

Some investors argue that Return on Invested Capital (ROIC) and Free Cash Flow (FCF) are superior long-term metrics compared to ROE. Let’s break down why.

Why ROIC Can Be More Reliable Than ROE

• ROE measures return relative to equity, which can be inflated by leverage. A company can juice its ROE by borrowing heavily, but that doesn’t make it a safer or better investment.

• ROIC, on the other hand, measures returns relative to all invested capital (equity + debt). This provides a more complete picture of how efficiently the business uses its total capital.

High ROIC businesses that can reinvest at those high rates for long periods tend to be the true compounders.

Why FCF Matters More Than Accounting Earnings

• Earnings can be manipulated by accounting choices.

• FCF shows the actual cash left after necessary reinvestment, which can be returned to shareholders or redeployed for growth.

• Ultimately, it is cash flow—not reported earnings—that funds dividends, buybacks, and acquisitions.

Example: Apple’s Evolution (2007–2020)

Apple provides an excellent case study.

• In the early 2000s, Apple’s ROE was volatile and didn’t look extraordinary.

• But by the time the iPhone launched in 2007, Apple’s ROIC and FCF margins skyrocketed. The company generated not just high profits, but massive free cash flow, which it reinvested into product innovation and share buybacks.

• From 2007 to 2020, Apple compounded at nearly 25% annually, far outpacing its early ROE figures.

This demonstrates why many investors prioritize ROIC + FCF over ROE.

4. Case Studies: When ROE vs PE vs ROIC Mattered

Case 1: Amazon (ROIC > ROE)

• For years, Amazon’s ROE looked unimpressive because it reinvested so aggressively.

• But on a ROIC basis, Amazon consistently deployed capital into high-return projects (AWS, logistics).

• Investors who only screened by ROE would have missed one of the greatest compounders of all time.

Case 2: Intel (High ROE, Poor Reinvestment)

• In the early 2000s, Intel had excellent ROE, but reinvestment opportunities dried up as the PC market matured.

• Without a strong reinvestment runway, even high ROE couldn’t sustain compounding.

• Long-term returns stagnated, teaching that ROE is only valuable when reinvestment opportunities exist.

Case 3: Coca-Cola vs PepsiCo (ROE + PE Balance)

• Coca-Cola enjoyed legendary ROE, but by the late 1990s, it traded at sky-high PE multiples.

• PepsiCo, with slightly lower ROE but a cheaper valuation and diversified portfolio, actually outperformed KO for much of the 2000s.

• Again: quality matters, but starting valuation can tilt the balance.

5. The Decade Question: If You Could Only Choose One Metric

If an investor could only choose one metric when making a 10-year investment decision, which would it be?

• ROE: Good proxy for profitability, but distorted by leverage.

• PE: Useful for entry point, but says nothing about the durability of the business.

• ROIC: Best measure of compounding ability relative to all capital employed.

The ideal combination is:

• High ROIC (proof of quality).

• High FCF conversion (proof of real cash returns).

• Reasonable PE entry (proof you didn’t overpay).

If forced to pick just one, ROIC adjusted for reinvestment opportunities is arguably the single best predictor of long-term compounding.

Final Thoughts

The debate between ROE and PE ultimately reflects a timeless truth: quality versus price.

• ROE captures the essence of business quality, but can be misleading if boosted by leverage or lacking reinvestment opportunities.

• PE captures valuation, but can make great businesses look “too expensive” in the short run, even if they compound for decades.

• ROIC and FCF provide a cleaner lens, tying profitability directly to reinvestment and cash generation.

For long-term investors, the sweet spot lies in finding businesses with high ROIC, strong free cash flow generation, and reasonable entry valuations. Over 10–20 years, these are the investments that turn into true wealth compounders.

As Charlie Munger would say: “The big money is not in the buying or selling, but in the waiting.”