Value Investing Talk With The Master (Part 3)
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’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.
Firstly, I would like to start with the definition of return on equity. ROE is simply the net income of a company divided by shareholder’s equity. ROE is also commonly referred to as “stockholder’s return on investment.” It reveals the rate at which shareholders are earning income on their shares. Whether this rate can be considered good or not largely depends on the company and industry.
For instance, a low ROE would be regarded as bad for a consulting company since it’s in a sector that doesn’t necessitate assets to start yielding an income. Then again, a low ROE would be satisfactory and even fine in the oil refining industry because it is an sector that requires numerous pieces of infrastructure to start yielding 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.
A sound time frame for studying the ROE of a company is 5 to 10 years. Such a period of time will give you a reasonable indication of the historical performance of the company. A good idea is to access past financial reports of chosen companies, most of which typically have their reports uploaded on their website. Additionally, it would be effective to enquiry and find the average ROE of chosen sectors 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!
Tags: Debt, Finance, Investing, Investing, rent, trading
