Roger Montgomery: Importance of ‘return on equity’

Perhaps the single most important factor in the identification of a wonderful business is a number, a simple ratio, the return on equity. That is, the level of net income as a percentage of shareholders’ equity. The actress Mae West once said, “Too much of a good thing is wonderful”, and return on equity is like that. It is a measure of the earning power of a business and while accounting focuses on providing an estimate of the business’s performance and position, the economics reveals the true picture. The wealthiest man alive today, Warren Buffett, is an enormous fan of return on equity as demonstrated by the statements: “Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe [a more appropriate measure] of managerial economic performance to be return on equity capital.” And: “The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” To read the full article click the (VIEW LINK)

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