The Warren Buffett Way
, many measurements, numbers, and ratios are usedin evaluating a business. When evaluating the business, it is important to remember management is also taken into consideration along with these figures. The following arewhat we have determined to be the most important.
Return on Equity (pg. 110)
When evaluating annual performance, Buffett states that return on equity isimportant to look at. He believes that it is a more important measurement than earnings per share. This measurement is defined as the ratio of operating earnings to shareholders’equity or total equity, which is found on the balance sheet. However, Buffett does notuse the ROE stated in the financial statements; he tells us that several adjustments should be made to this ratio to make it more accurate. The first adjustment he suggests is thatsecurities should be valued at their purchase price rather than their current market pricewhen determining shareholders’ equity. The second adjustment that is recommended is toremove all capital gains and losses, and any extraordinary items when figuring operatingearnings.This measurement is important to Buffett because it demonstrates management’sability to generate above-average returns with the amount of capital employed. SinceROE is the product of profit margin on sales, total asset turnover, interest burden, tax burden and financial leverage, Buffett looks favorably on high ratios in all of these,except having high financial leverage. He does not like high financial leverage because itimplies a lot of debt. To Buffett, good quality companies should be able to produceenough cash without using much debt. Somewhat comparable to ROE, he does not like