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.

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 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.

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.

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!

The fourth part of this series deals with the debt/equity ratio, which is another key component of Warren Buffett’s legendary methodology. In fact, it is a component that the man himself treats very carefully when deciding which stocks to invest in. Just like the return on equity in the previous part of this series, it is an equation that is commonly used in finance, however, Buffett is the one who makes the most and greatest use of it.

The components that make up the debt/equity ratio are fairly obvious and I’m certain that many people first heard of it in high school in a commerce or business class. But just in case, there’s still some confusion, I will give a quick, brief explanation. The debt/equity ratio is given by total liabilities of a company divided by shareholders’ equity.

Both of these are freely available on a company’s balance sheet (sometimes called the statement of financial position). Taking these numbers from these reports is known as taking its ‘book value’. On the other hand, if the debt and equity of the interested company are traded publicly, you have the option of using the market value instead. In addition, you may also choose to use a mixture of both the book and market value.

The ratio illustrates the proportion of debt and equity the company is utilising to support its assets. If a ratio is high, this corresponds to a situation where debt is mainly shoring up the company. The principal dilemma with a high ratio is that it renders earnings volatile and leaves it at the mercy of interest rates, which can be expensive.

Buffett pays a lot of attention to the results of this ratio and the reasons behind this is a important lesson for all investors. He doesn’t differ from other investors, in that he would much prefer companies which have a low amount of debt and the reasoning behind this that a low amount of debt implies income growth is being derived from shareholders’ equity rather than borrowed money in the form of loans. The problem is that if a company uses loans to prop up its income, this normally leads to a vicious cycle of debt and repayments forming which in inherently inconsistent and dependant on the level of the rate of interest.

What investors should take from this part of the series is that they should focus on companies that possess a low ratio, but not just any low ratio, it must be low compared to other companies in the same sector. It’s not difficult to get the numbers necessary to calculate such a ratio, because as I highlighted in a previous paragraph, this is all available on company reports which themselves are publicly available.

Several investors choose to only use long-term debt rather than total liabilities when calculating the ratio. This could be more effective and handy as stocks investing is for the long run not the short run. This doesn’t come from my own personal view, but in fact it’s part of Warren Buffett’s own methodology.

The fifth and final section of this publication will concentrate on one final component of Buffett’s methodology known as profit margins. Coming soon!

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.

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 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.

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. Stay tuned!