- business

What is Return on Equity and Why does Warren Buffett Like it So Much?

Investors should really have a good understanding of the importance of return on equity. This term is defined as the amount of income that is returned based on the equity of the shareholders. It gives an accurate measurement of the amount of money a business profits based on what shareholders have invested in the business. It is always represented as a percentage.

The equation for Return on Equity is calculated by the net income divided by the shareholder’s equity. The net income is calculated each fiscal year. It is calculated before any dividends have been paid to the stockholders.

So, what does this particular return mean in the business world? Most people find it to be a useful tool used to compare profits of several companies in the same type of industry. Stock traders can use it to help them make informed decisions for their stock investments.

One of the most famous and successful people in the trading industry is Warren Buffet. He believes that the return on equity is probably the most important factor used to make informed stock investments. He has done extensive studies regarding the stock market, and in his studies has found that with a higher Return on Equity, businesses can invest more of their capital funds instead of having to borrow money to improve their business operations.

What does this mean for shareholders? Simply put, it provides more stability for the investments made. When businesses have a solid Return on Equity, the business is more likely to flourish and thrive in the stock market. This is definitely an added advantage to stock traders.

What Percentage Should you Look For?

Since this term is something that is always fluctuating. Studies have shown that the average return for companies in america is right at 11%. While this is the average, it is usually a good idea to look for businesses that have a ROE percentage that is higher than the national average. I’m sure you already figured that out by now.

What would Warren Buffet say? He would say to look for the businesses that have at least 14% Return on Equity. This makes for a much smarter investment, and you are much more likely to have success in your stock market endeavors if you use this as a rule of thumb. The Return on Equity is definitely something that you want to use as a basic principle when making your investment decisions.

The Risks to consider

As with anything involving the stock market, comparing company percentages can sometimes be risky. Companies can sometimes start out with high percentages, and they can dwindle down over the years. This is why you should always look at the averages and the trends. If it is on a steady decline, then chances are that is going to be the continuing trend and it may be wise to make your investments elsewhere.