The Buffett Guide To Value Investing (Part 3)
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 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.
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!
