The above picture is from the 1987 Letter of Warren Buffett to shareholders in which he mentioned how and why ROE is necessary for the company.
What is ROE?
In simple words, ROE is how many dollars/ Rupee a company earns for EACH dollar / Rupee of investors. Here investors’ money also included Reserve or Undistributed Profit.
Warren Buffett is concentrating because EPS is only for that quarter or year. It is not taking Equity into account. When the company comes into existence, the company is not distributing all of its Profit. Some part of Profit is there with a company.
By taking ROE into account, Warren Buffett is indirectly taking the efficiency of management into account. As if Administration makes the wrong Decision, ROE will come Down.
More interesting is DuPont Formula. The formula proves why ROE is important.
The Formula is Profitability * Asset Turnover * Leverage
Warren Buffett concentrated on Profitability. He also mentioned Leverage and advocated for Low or Zero Debt levels.
This tenet also shows the importance of Discounts available. A company with high ROE and Low PE is an excellent investment. And that is what Value investing is all about.
