UFO Sightings

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 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 instance, a low ROE is ackowledged as being bad for a consulting firm because it is in an industry that doesn’t involve assets to start rendering revenue. On the contrary, a low ROE would be considered pretty reasonable in the oil industry because it’s an industry that necessitates various components of infrastructure to start rendering revenue.

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.

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 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!

Filed under: Finance