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Buffett and Beyond: Uncovering the Secret Ratio for Superior Stock Selection, + Website, 2nd Edition by Joseph Belmonte

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Chapter 11

Clean Surplus ROE—the Only Comparable Efficiency Ratio

Developing the Tools to Determine the Probability of Predictability

You are now aware of a very straightforward method for calculating a return on equity that is truly common to all stocks. We are calculating both the return (net income) and the owners’ equity the same way for each individual stock. We are comparing apples to apples and peaches to peaches.

Let's review by thinking once again of the bank account examples shown in Table 11.1. The account of Bank A is earning more money in year five ($14.60) because it has a higher equity (asset) base ($146). How did Bank A accumulate a higher equity (asset base) than Bank B when both began year one with the same amount of equity? Because Bank A earned a greater return on its asset base. Since it earned a higher return and reinvested all the interest back into the account, Bank A was thus able to retain more dollars than Bank B.

Table 11.1 Bank A and Bank B—Beginning with $100

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Now here's the ultimate, most important, mind-shattering, earth-shaking saber-rattling question in the entire world of investing. If you had the opportunity to buy the assets of the account in Bank A or the assets of the account in Bank B, which account would you be required to pay more for?

Now you are beginning to understand why some stocks sell for more than other stocks. They are earning ...

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