Buffett has said that Return On Equity (ROE) is one of the best valuation metrics, and it is one of the key metrics for looking at corporate profitability。

This article will introduce the concept of return on shareholders' equity and how to apply it in stock selection to understand the true meaning behind the theory.。

Return On Equity (ROE), also known as return on equity, return on equity, return on equity, equity margin, net asset margin, etc., is a financial indicator to measure the efficiency of business operations.。ROE represents how much revenue a company can generate using the funds invested by shareholders, reflecting the effective utilization of its own funds。

Generally speaking, the higher the return on shareholders' equity, the more money the company earns back for shareholders, while the ROE remains high for a long time, which also represents the company's operating efficiency and financial soundness.

Profit after tax (Profit after tax) refers to the total income of an enterprise (operating income + other income + interest income) after deducting all costs and expenses (operating costs + sales and marketing expenses + administrative expenses + other expenses + financial expenses) and taxes.。

Shareholders' equity (Shareholders' Equity) refers to the true value of a company's assets, which is obtained by subtracting all liabilities from all assets.。

From another perspective, ROE is essentially a measure of the return generated by a company's net assets。

Reasonable value of ROE

The higher the value of ROE, the better the efficiency of making money, the industry usually ROE > 15% as a stock selection condition;。

However, it should be noted that ROE is calculated as starting working capital, and the calculated value is actually the rate of return of the founding shareholders.。Most investors buy on the basis of the market price of the stock, so ROE can only be used as a measure of the efficiency of the company's money, can not simply think of ROE as the return on investment.。

And when evaluating ROE, comparing it with the ROE of companies in the same industry or field, the resulting values are more informative.。In the analysis, it can also be used in conjunction with other metrics, such as cost-benefit ratio (PE), earnings per share (EPS)。

Four pitfalls of ROE stock picking

Companies with high ROE may be strong on the outside and strong on the inside, looking good but actually over-taking on huge risks by borrowing; companies with low ROE may be affected by the economic environment, such as epidemics, concept stocks, boom cycles and other factors affecting their operations, which in turn affects the value of ROE。

However, there are bound to be weaknesses in either valuation metric, so it's important to keep an eye on the following potential pitfalls when using ROE analysis to pick stocks。

falsification of accounts

Whether it is multinational enterprises or small and medium-sized enterprises, there may be accounting fraud.。Because many times listed companies are forced to raise capital, and some individuals even manipulate their accounts in order to profit from it.。No matter how regulators prevent it and international financial reporting standards continue to improve, there will always be people who exploit the loopholes。Therefore, when analyzing corporate earnings, it is important to be aware of any abnormal data。

One-time profit

In the stock market, there is often a sudden surge in a company's earnings in a given year, and behind the sudden surge in performance is often a one-time profit, such as a one-time additional income, the sale of assets, or simply a book adjustment profit in line with accounting regulations.。This kind of profit can easily push up the ROE value, but the company's real profitability will not increase in the long run.。

debt risk

ROE is a formula that can be used to change the calculation in two ways: to expand net profit after tax or to reduce shareholders' equity.。

If an enterprise improves ROE by expanding net profit, it naturally belongs to healthy growth and is a good thing.。However, if companies rely on borrowing more money to pull down shareholders' equity, then with net profit unchanged, ROE will also increase artificially, creating the illusion of high ROE.。

And because ROE excludes corporate debt in its calculations, highly profitable companies may only be superficial, and behind them may be heavily indebted and take on huge financial risks.。In the event of a financial storm, a Great Depression and a sharp fall in the stock market, there will be a financial crisis or even bankruptcy at any time due to excessive borrowing.。

Low utilization of funds

Enterprises often keep some funds in hand to pave the way for subsequent business development and investment.。

However, retained funds represent a corresponding increase in shareholders' equity, affecting ROE values, so companies will find ways to make this temporarily useless funds, creating additional income.。Otherwise, the decline in ROE reflects the company's inability to use its funds efficiently and may affect shareholder confidence.。

SUMMARY

Almost all investors want to invest in companies that are profitable and stable over the long term, and ROE is a good reflection of the true picture behind the earnings report。However, there is no perfect valuation method in the world, there will always be weaknesses in different aspects, stock selection should refer to a variety of financial indicators at the same time, combined with different valuation methods, in order to screen out the really worth investing in good companies.。