Return on Equity

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. Benjamin Graham defines stockholders equity as: "the interest of the stockholders in a company as measured by the capital and surplus."

A high return on equity means that surplus funds can be invested to improve business operations without the owners of the business (i.e. stockholders) having to invest more capital. It also means that there is less need to borrow. On the subject of borrowing, debt can increase the return on equity, provided the return on capital from the debt is greater than the interest paid on the debt.

What kind of returns on equity should investors be looking for? Benchmarks could be the return on investment grade bonds or the average rate of return of companies in the market. In 1972 Mr. Buffett identified the average rate of return on equity of corporate America was 14%; in 1981 it was 11%. This past decade the average return on equity was north of 20%, thanks to all the cheap debt financing which was readily available. We all know how that turned out. That's why Mr. Buffett prefers to own companies with little or no debt.

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