Warren Buffett believes that the return that a company gets on its equity is one of the most important factors in making successful stock investments.
DEFINING EQUITY
Benjamin Graham defines stockholders equity as:
‘The interest of the stockholders in a company as measured by the capital and surplus.’
CALCULATING OWNER’S EQUITY
Investors can think of stockholders equity like this. An investor who buys a business for $100,000 has an equity of $100,000 in that investment. This sum represents the total capital provided by the investor.
If the investor then makes a net profit each year from the business of $10,000, the return on equity is 10%:
10,000 x 100
100,000
100,000
If however the investor has borrowed $50,000 from a bank and pays an annual amount of interest to the bank of $3500, the calculations change. The total capital in the business remains at $100,000 but the equity in the business (the capital provided by the investor) is now only $50,000 ($100,000 - $50,000).
The profit figures also change. The net profit now is only $6500 ($10,000 - $3,500).
The return on capital (total capital employed, equity plus debt) remains at 10%. The return on equity is different and higher. It is now 13%:
6,500 x 100
50,000
50,000
The approach to financing its operations by a company can obviously affect the returns on equity shown by that company.
WHY WARREN BUFFETT THINKS THAT RETURN ON EQUITY IS IMPORTANT
Just as a 10% return on a business is, all other things being equal, better than a 5% return, so too with corporate rates of returns on equity.
- Also, a higher return on equity means that surplus funds can be invested to improve business operations without the owners of the business (stockholders) having to invest more capital.
- It also means that there is less need to borrow.
