Buffett Beyond Value: Why Warren Buffett Looks to Growth and Management When Investing

Chapter 23. Key to Success: ROE and Other Ratios

The best gauge of the success of an enterprise is the percentage earned on invested capital.^[180]

—Benjamin Graham, David Dodd, and Sidney Cottle

You are likely to earn a good return on your stock in the long run only if the underlying business is earning a good return on its capital. From the shareholders' perspective, return on equity (ROE) is usually the best yardstick, as it isolates the returns that belong to the shareholders from the returns to the enterprise as a whole.

ROE: Underlying Performance of a Business

Buffett often mentions financial ratios when discussing a business's underlying performance. The most important of them all—return on equity (ROE)—is net income divided by the book value of shareholders' equity. Because Costco is a well-run business, I use it as an example to illustrate some of the notable aspects of ROE and related issues. Let's look at Costco's ROEs for the past 12 years in Table 23.1.

Year after year, Costco has produced an ROE in excess of 10 percent, averaging 12.9 percent over the most recent 12 years. Have the stock returns been about the same? Costco's fiscal year usually ends at the end of August, and earnings data are publicly known by November of the same year. For comparing the 12-year ROEs to stock returns, we should therefore use the 12 years of stock returns from the end of November 1996 until the end of November 2008. During this period, Costco's stock price (split adjusted) went up from $11.60 ...