W. Buffett Shares His Secret Formula (Part 3)

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W. Buffett Shares His Secret Formula (Part 3)

Author: MartinSejas Total views: 1 Word Count: 475

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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 will address the definition of return on equity. ROE simply constitutes the earnings of a company divided by shareholder's equity. ROE is also frequently called the "stockholder's return on investment." because it reveals the rate at which shareholders are bringing in income on their shares. This rate can be considered both good or bad, however this is largely dependent 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.

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 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!

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About the Author

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 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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