This third part of this series focuses on another important 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 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 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.

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 sound time frame for studying the ROE of a company is 5 to 10 years. Such a period of time will give you a reasonable indication of the historical performance of the company. A good idea is to access past financial reports of chosen companies, most of which typically have their reports uploaded on their website. Additionally, it would be effective to enquiry and find the average ROE of chosen sectors 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!