Return on Equity

Return on Equity (ROE) is the amount of after-tax profits a company earns on the capital that has been invested in the business. It is one of the attributes of quality that successful investors like Warren Buffett look for in companies.

A company with consistently high ROE is usually one that has a competitive advantage that allows it to continue to earn high rates of return.

“What we really want to do is buy a business that’s a great business, which means that business is going to earn a high return on capital employed for a very long period of time… The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.” Warren Buffett

“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.” Charlie Munger

Research from Investor’s Business Daily shows that the greatest growth stocks of the past 50 years had ROEs of 17% or more. The biggest winners had ROEs of 25% to 50%.

As you can see, it is not about buying stocks with high Return on Equity in their most recent financial year. We need to be able to identify companies that can generate consistently ROE of 18% to 20% or more.

This means that the trend of ROE is an equally important factor of analysis than simply the most recent ROE.