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'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 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.
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 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 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!
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About the author: Martin Sejas is the owner 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 mission is to become the 'one-stop shop' on the best stocks trading websites and programs on the World Wide Web.
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