This 3rd section of this series revolves around another significant element of Warren Buffett’s hugely successful methodology – return on equity (ROE). Now, you may have heard the term “return on equity” before. It’s not a relatively new concept, and it is one that is commonly used in finance. However, its importance must not be taken for granted.
It is one thing to recognize the term “return on equity”, but it is another thing to know how to employ it to a tremendously favorable effect. Put differently, Warren Buffett utilises an instrument that is employed by essentially everybody in the sector, nevertheless, he applies it in a way that’s different from everyone else, and this is essentially the lesson that all investors ought to learn.
Firstly, I will address the definition of return on equity. ROE simply constitutes the earnings of a company divided by shareholder’s equity. ROE is also frequently called the “stockholder’s return on investment.” because it reveals the rate at which shareholders are bringing in income on their shares. This rate can be considered both good or bad, however this is largely dependent on the company and industry.
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.
Nevertheless, the type of company or sector is by and large not relevant in this component of Warren Buffett’s methodology (even so, there’s an exception which is covered in Part One). The reason why ROE is of crucial importance to him is to ascertain whether or not a company experiences a consistent performance in comparison with other companies in the same sector. The key word here is consistency. Buffett will always opt for a company that has a coherent ROE over one that has an ROE that endlessly wavers. As a matter of fact companies, which hinge on the commodities such as petroleum and gas, don’t make up his favourites list and commonly have a mostly fluctuating ROE. This point is covered in Part One of this series.
An appropriate time frame for studying the ROE of a company is 5 to 10 years. Such a time frame will give you a sound idea of the historical performance of the company. One way of doing could be opening up past financial reports of a handful of 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 a handful of industries to compare company performances.
The next component of this series will concentrate on another crucial component of Buffett’s methodology – debt/equity ratio, and how several investors often neglect it. Keep an eye out for it!