The secret weapon of Warren Buffett – ROE

The secret weapon of Warren Buffett – ROE

In the last article, we discussed Price to Book Value (PBV), and also mentioned that it is best used with another financial ratio – Return on Equity (ROE), which is always used by the world’s famous value investor Warren Buffett.

Warren Buffett believes that ROE is one of the most important factors in making successful stock investment decisions, and also important in finding out how well a company is doing.

According to Benjamin Graham, equity refers to the interest of the stockholders in a company as measured by the capital and surplus.

As such, the ROE is a measurement of how well a company is using its capital and reinvesting its earnings to generate more profits.

Let’s look at its formula:

ROE = Net Profit ÷ Shareholders’ Equity × 100%

For example, for the Financial Year ended 2013, RHB Capital registered a net profit (attributable to equity holders) of RM1,831,190,000, and as at financial year end, its equity (excluding non-controlling interests) stood at RM16,739,071,000.

Based on the information, the ROE of RHB Capital is:
ROE = RM1,831,190,000÷ RM16,739,071,000 × 100%
= 10.9%

Same as PE and PBV financial ratios, the ROE is a good ratio for comparing the fundamental performance of one company versus another in the same industry.

The higher the financial ratio, the more efficient management is in utilising the shareholders’ equity, and of course, the better the returns to investors.

As such, a 10% ROE of a company, all other things being equal, is better than a 5% ROE of another company in the same industry.

Apart from using the ROE to compare companies in the same industry, you may also look at the past historical ROE trend of the company.

It is important to look at the trend in ROE to ensure that it is not steadily declining. A rising ratio is a great sign.

The rising ROE means that the company is increasing its ability to generate profit without the need of having to invest more capital.

In the next article, we will discuss the relationships between PBV and ROE, and how to use these two indicators to identify whether a stock is undervalued, overvalued or fair value.

Tip: Where to get the figures?

For net profit, you can get it from the Income Statement (Profit and Loss) of the annual report; and
For shareholders’ equity, you can get it from the Statements of Financial Position (Balance Sheet) of the annual report.

Reference:
http://www.buffettsecrets.com/return-on-equity.htm