W. Buffett Shares His Secret Formula (Part 3)

by: MartinSejas
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This third part of this series focuses on another important 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.

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.

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 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!

About the Author

Author Martin Sejas is the chief writer of Stocks-And-Commodities.com, a leading stocks trading website dedicated to finding the best and the latest strategies and techniques for stocks and commodities trading. Its goal is to become the 'one-stop shop' on the best stocks trading websites and programs on the World Wide Web.  

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