A company?s return on equity is an important financial metric. In fact, it is a prized variable that American billionaire investor Warren Buffett likes to look for in the businesses that he invests in.
According to Robert Hagstrom?s book, The Warren Buffett Way, Buffett?s criteria for selecting investments consists of (emphasis mine) ?a simple, understandable business with consistent earning power, good return on equity, little debt, and good management in place.?
Generally speaking, businesses with good economic characteristics and a strong competitive advantage have high returns on equity…
A company’s return on equity is an important financial metric. In fact, it is a prized variable that American billionaire investor Warren Buffett likes to look for in the businesses that he invests in.
According to Robert Hagstrom’s book, The Warren Buffett Way, Buffett’s criteria for selecting investments consists of (emphasis mine) “a simple, understandable business with consistent earning power, good return on equity, little debt, and good management in place.”
Generally speaking, businesses with good economic characteristics and a strong competitive advantage have high returns on equity even without borrowing large amounts of money.
Thus, finding companies with a consistently high Return on Equity (ROE) on relatively un-levered balance sheets over a long period of time might help identify attractive investing opportunities.
Over the past five years, four companies, SIA Engineering (SGX: S59), Kingsmen Creatives (SGX: 5MZ), Japan Foods Holding (SGX: 5OI), and ARA Asset Management (SGX: D1R), have beaten the benchmark Straits Times Index (SGX: ^STI) handily as shown below.
|Company||Price on 15/10/08*||Price on 15/10/13||Change (%)|
|ARA Asset Management||S$0.262||S$1.72||556%|
|Price on 23/02/09**||Price on 15/10/13||Change (%)|
|Japan Foods Holding||S$0.167||S$0.755||352%|
|*Share prices on 15 Oct 2008 and 23 Feb 2009 are adjusted for stock splits, if any.**Japan Foods Holding got listed only on 23 Feb 2009.|
Source: Yahoo and Google Finance
If we turn to their long-term return on equity figures, shown in the table below, the reasons for their market-beating performance becomes clearer.
|Company||Average ROE over past five completed-financial years||ROE for last-12-months’ results|
|Japan Foods Holding||28.4%||28.2%|
|ARA Asset Management||40.5%||29.3%|
Source: Company’s annual reports, earnings releases and author’s calculations
These four companies have exhibited consistently high RoE for a number of years, while employing low leverage, which suggests strong economic characteristics and above-average levels of profitability. That goes some way to explain their long-term share price returns.
Foolish Bottom Line
When used wisely, the RoE of a company can be a powerful tool to help investors unearth possibly great investing opportunities.
But despite its apparent usefulness, the RoE is not perfect. While it can help find companies with strong competitive advantages, it cannot tell us where those advantages might lie.
As investors, we will still have to assess these businesses qualitatively to find out more. After all, a company’s future results are not a function of its past RoE but how it makes use of its assets in the years ahead.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing owns shares in Kingsmen Creatives and Japan Foods Holding.