W. Buffett Shares His Secret Formula (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.
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 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.
Notwithstanding, the type of company or sector is broadly speaking irrelevant in this element of Warren Buffett’s methodology (nevertheless, there exists an exception which is outlined in Part One). The reason why ROE is considered very important to him is to verify whether or not a company has experienced a consistent performance well in comparison to other companies in the same industry. The fundamental word here is consistency. Buffett will always favour a company that has a coherent ROE over one that has a ROE that incessantly wavers. In point of fact companies, which ride on commodities such as oil and gas, are by far not his favourites and tend to have for the most part a unsteady ROE. This point is outlined 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 part of this series will focus on another important element of Buffett’s methodology – debt/equity ratio, and how many investors frequently overlook it. Stay tuned!
Tags: Debt, Finance, Investing, Investing, rent, trading
