This 3rd component of this series centers on another crucial component of Warren Buffett’s enormously successful methodology – return on equity (ROE). Nowadays, you might have used the term “return on equity” earlier. It is not a comparatively novel concept, and it’s something that is typically applied in finance. Nevertheless, its importance must not be underestimated.
It’s one thing to know what “return on equity” is, while it’s another thing to know how to use it to a hugely positive effect. In other words, Warren Buffett uses a tool that is used by basically everyone in the industry, however, he uses it in a way that no one else does, and this is the lesson that all investors should learn from.
First off, I would like to point to the definition of return on equity. ROE is equal to the net earnings of a company divided by shareholder’s equity. ROE is also typically associated with the phrase “stockholder’s return on investment.” It discloses the rate at which shareholders are gaining money on their shares. Whether this rate can constitute a good return or not depends for the most part on the company and sector.
For example, a low ROE would be considered bad for a consulting firm because it is in an industry that doesn’t require assets to start generating an income. On the other hand, a low ROE would be acceptable and even good in the oil industry because it is an industry that requires a lot of infrastructure to start generating an income.
However, the type of company or industry is generally irrelevant in this part of Warren Buffett’s methodology (however, there is an exception which is explained in Part One). The reason why ROE is important to him is to see whether or not a company has consistently performed well in comparison to other companies in the same industry. The key word here is consistency. Buffett will always choose a company that has a consistent ROE over one that has an ROE that continuously fluctuates. In fact companies, which depend on the commodities such as oil and gas, are his least favourites and tend to have a largely fluctuating ROE. This point is explained in Part One of this series.
A good time frame for analysing the ROE of a company is 5 to 10 years. Such a time frame will give you a good idea of the historical performance of the company. A good idea would be to access past financial reports of selected companies, most of which would have their reports uploaded on their website. In addition, it would be useful to research and find the average ROE of selected industries to compare company performances.
The next part of this series will focus on another important element of Buffett’s methodology – debt/equity ratio, and how many investors frequently overlook it. Watch this space!