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Why Return on Equity is important for Stock Market Investment?

Return on equity is one of the most important metrics for the stock market investors. This metric helps investors to identify  profitable stocks for trading at the stock market.Stock traders should research for companies with high ROEs and select the most appropriate one for them .ROE shows that how much company is generating returns as compared to its equity. Companies with high ROE are always in position to pay high returns to the shareholders.

Return on equity can be calculated by the following formula :

Return one equity = Net Income/Shareholders equity X 100

Net income is the income  of the company after paying income tax and before paying dividends to the shareholders. Shareholders equity is calculated by subtracting Total assets from the Total liabilities.

What Warren Buffet thinks about Return on Equity?

Warren Buffet is probably the most successful stock market investor of last two centuries.Successful stock market investors like Warren buffet give extreme importance to the return on equity.He feels that  return on equity is one of the most important metrics while investing and looking for most profitable stocks . High ROE clearly depicts the high income generating potential of the company stock.

The high returns on  equity are better than the low returns on equity.Warren buffet believes that company with high ROE has a very good chance to reinvest  in the company expansion projects.A company with high ROE has no need to burrow more funds for its  future assets purchases.

Warren buffet always gave special importance to the return on equity measures. During the mid eighties ,he identified 11 % as the most appropriate ROE for companies.The companies with ROE of 11 % or more than 11 % were preferred by Warren buffet.He also gave importance to the bond rates change while investing in bonds for long term investment.

It is very important to note that most of the companies in Berkshire Hathaway portfolio have very high return on equity.This is very true for at least last ten years of its investment history. Warren buffet has heavily invested in companies like Coca Cola.Coca Cola has a very high return on equity for last ten years or so.It had a average ROE of 30.8 from 2002 to 2011.

Return on Equity is very important for investors while identifying most reliable investment option in the stock market.It helps them to measure the growth potential of any company.According to most of the stock market experts,fifteen percent is the minimum ROE benchmark for a good company.

The standard ROE are different for different industries.We cant compare ROE of one company of industry with another company of different industry. This comparison is unrealistic and misleading.

Apart from the usefulness of the ROE,we cant solely rely on this single metric for devising long term investing strategy.So sometimes , ROE calculations are very misleading.It must be kept in mind that it is impossible for companies to grow its net earnings more than its ROE.They have to burrow more to increase their revenue but it decreases the EPS of the company.Investors must know to utilize different types of technical and fundamental analysis tools to devise a long term investing strategy for their portfolio.

About Emaad Qureshi