In the traits I look for when picking stocks, one that I took from Warren Buffett’s playbook is Return on Equity (ROE).  ROE is a measure of how well a company is run.  In this article we look at ROE and how to use it when picking companies to invest in.

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What is ROE?

Equity is the value of a company. It includes the buildings and equipment, inventory, and cash they have in their checking accounts. As a company earns money, they send some of it out to shareholders through dividends or by repurchasing shares of their stock. The rest they reinvest in the business to increase the amount the company earns the next year, over the next decade, and so on. ROE is basically the return that a company makes on the money that it keeps and invests in the company. How well are they using the money they keep and reinvest to generate more money?

A good ROE shows that the management team knows how to use resources to generate profits. They are creating things that sell and bring in money for the company. Maybe they are buying new machinery, creating better software, or doing research and development to make better profits. Whatever it is, a good ROE shows that it is working. These are the kind of companies you want to own.

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What kind of ROE should you look for?

You want companies that have a solid ROE, but that is not so large that it is not sustainable. You want to find companies that maintain a good ROE year-after-year, not just those that have a good year and then see a decline. These are the companies that will grow and become multi-multiple returns if held for a decade or more.

Look for companies with ROE of around 15-25%.  That is a reasonable range that can be sustained over time. It is also important to compare the ROE of the company you’re studying against that of its peers in the industry, since this will indicate how well it is run compared to its competitors.  Note that some industries, such as retail, tend to have larger ROE’s than other industries, so ruling out a company simply based on ROE of less than 15% would not be advisable. Instead, you want to find companies that are doing well compared to others in the same industry. You’ll want to then build a portfolio that includes stocks in different industries.

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ROE is just one factor to look at when choosing stocks, but a substantial one. Now that you know, add it to your selection criteria. Outperforming the markets with individual stocks is all about choosing the right companies as investments. Using ROE will help you do this.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.