← Back to Explore
concept
🕰2 min read
🎵Wisdom Density:
Moderate
🧭12 concepts
💬1 quotes
👁 -- readers

Return on Equity (ROE)

Return on Equity (ROE) is the primary metric Warren Buffett uses to judge the economic performance of a business and its management. He favors ROE over Earnings Per Share (EPS) because it measures how effectively a company uses its existing capital to generate profits.

📍 Origin

Buffett formally introduced ROE as Berkshire's internal benchmark in the 1971 Letter.

"The primary test of managerial economic performance is the attainment of a high return on capital employed (without undue leverage) and not consistent gains in earnings per share."

📅 Chronological Evolution

  • 1971 Letter: The Performance Yardstick.

    • Logic: Buffett argues that EPS can be easily manipulated through share issuance or accounting tricks, whereas ROE forces a focus on the efficiency of the business model.

  • 1977 Letter: Business Classification.

    • Shift: Buffett begins to categorize all businesses into those with high ROE (Wonderful Businesses) and low ROE (Mediocre Businesses).
    • Insight: A business that earns 20% on equity can grow without borrowing; one that earns 5% must borrow or issue stock just to keep up with inflation.

  • 1980 Letter: The Inflation Threshold.

    • Evolution: Buffett argues that in a high-inflation environment, a "good" ROE must be significantly higher than in a stable one.
    • Quote: "If inflation is 12%, a business earning 12% on equity is essentially standing still in real terms. It provides no real growth for the owner."

  • 1981 Letter: The Crossbar of Passive Returns.

    • Evolution: Buffett introduces The Crossbar, comparing a business's ROE to the "passive return" available from bonds.
    • Logic: If a business earns 14% ROE but tax-exempt bonds yield 14%, the business is essentially a shell for what could be done passively. Total investment return is only "Value-Added" when it clears this high crossbar.

🔗 Connections