Sunday, April 5, 2009

Ignore The Headlines And Concentrate On Value Part II

As I said in my previous post concentrate on the fundamentals. We as investors are constantly bombarded with news via 24 hour news channels, the news paper and now that Ultra 24 hour news channel The Internet. Hey information is great and now we can receive more of it and at a faster speed than ever. As an astute investor one needs to turn off the hype and noise and concentrate on those fundamentals. I mentioned earlier terms such as book value and free cash flow, well their are other important things to look at when buying into a business. For example One of the most important profitability metrics is return on equity [or ROE for short]. Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. If you think back to lesson three, you will remember that shareholder equity is equal to total assets minus total liabilities. It’s what the shareholders “own”. Shareholder equity is a creation of accounting that represents the assets created by the retained earnings of the business and the paid-in capital of the owners.

A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company’s return on equity compared to its industry, the better. This should be obvious to even the less-than-astute investor If you owned a business that had a net worth [shareholder’s equity] of $100 million dollars and it made $5 million in profit, it would be earning 5% on your equity [$5 / $100 = .05, or 5%]. The higher you can get the “return” on your equity, in this case 5%, the better.

Some businesses that cosistantly have high returns on equity are Philip Morris International $PM w/59% ROE, Johnson & Johnson $JNJ w/30% ROE, and Coca Cola $KO w/28% ROE.

Return On Equity is another investment metric used by many famed Value Investors such as Warren Buffett, Bruce Berkowitz, Mohnish Pabrai and many other notabe investors.

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