Buffett & Munger

Lessons from the Masters of Value Investing

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Return on Equity

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Return on Equity (ROE) is net profit after tax and abnormal items divided by shareholders' funds (equity).  Shareholders' funds are derived from the money contributed by shareholders in the purchase of shares when initially issued plus any funds retained by the company from profits that are not paid to shareholders as dividends - called retained earnings. "ROE provides an assessment of how well a firm uses shareholders' money and is the most important business ratio of all. ROE is also a number that is devoid of share market hype".  

This ratio measures the business organization's efficiency at generating profits of net assets and shows how well the company is doing with investment money. Return on equity is calculated as fiscal year's net income divided by the total equity and usually expressed as a percentage.

Return on equity (ROE) = Net Income / Total Equity

 Standard & Poor's Quality Rankings divides stocks into categories: A+, A, A-, down to C.  Standard & Poor's has been amassing this data since 1956. A- is "Above Average".   The ROE for Berkshire Hathaway's category is 14 per cent.  Warren Buffett is a great advocate of measuring return on equity and employs it as one of six criteria in selecting a stock for investment or a company to purchase.  He has also suggested 14 per cent as a desirable target.  

Usually if the ROE is high, the business organization is considered as profitable and many investors will be willing to invest. But ROE does not give you the right picture in some cases. As an example, some industries have a high ROE as they do not require many assets such as software development companies. But some industries such as oil refineries require a huge amount of initial investment and assets even before it starts generating any income. In the latter case, ROE will be very low. So, in these cases, no one can conclude that software companies are better investments than oil refineries.

If you are interested in making an investment, return on equity is one of the critical measures to look at. One good practice is to calculate the growth on ROE. This is done by taking a period and calculating the ROE at the beginning and the end. If there is a positive growth of ROE, then it is assumed that the earnings have been properly invested in the company and the company is growing.

The standard formula for ROE, DuPont Formula is used by almost all industries for calculating their ROE by breaking down ROE in to three components for making the calculations easy.


Last Updated on Wednesday, 19 November 2008 11:41  

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Warren Buffett