There is a lot that can be learned from the greatest investor of all time. There have been many books, magazine articles, and television programs about Warren Buffett. In helping to make us all better investors, we have been looking at specific things that Buffett looks for in an investment. So far, we have covered more than half of the investment criteria that Buffett uses. Today, we will cover number 6 in our list of 10 Things To Look For When Buying A Stock series.
Return on equity is important because it helps you to see how effectively a company is using your investment. Return on Equity measures how fast a company can grow earnings. This is the amount of net income that is returned as a percentage of shareholders equity. ROE measures the rate of return on your ownership interest.
The formula for Return on Equity is expressed as follows:
Return on Equity = Net Income/Shareholders Equity
This is a useful metric for comparing the profitability of one company to another. Buffett looks for companies whose return on equity percentage is greater than that of its competitors. For example, Buffett has been a long time shareholder of Coca Cola Inc. (NYSE: KO). One of the things that Buffett has loved about Coca Cola is the company’s high return on earnings. Coke has a 29% return on earnings which is significantly higher than most industry competitors.The minimum ROE that Buffett likes to see in a stock is 15%.
While ROE is an important statistic, it should not be used by itself. Companies with large amounts of debt can have above average ROE’s because of their use of leverage. For example, banks were able to generate high ROE’s by loading their balance sheets up with debt instruments. It is best to avoid these risky type of investments with high ROE’s and high debt ratios. Companies with low debt levels and high returns on equity are often the perfect combination for value investors.
Here are 5 companies in distinctly different industries with above average ROE’s:
Netflix (NASDAQ: NFLX)
Colgate Palmolive (NYSE: CL)
Campbell Soup (NYSE: CPB)
Starbucks (NASDAQ: SBUX)
3M (NYSE: MMM)
Disclosure: The author holds no position in these stocks