In his 1978 Berkshire Hathaway Letter to Shareholders, Warren Buffett stated.
“We believe a more appropriate measure of managerial economic performance to be return on equity capital.”
Measuring the performance of management of a business is a tricky proposition as there are no direct ways to measure it. We have the overall performance of the business, of course. Additionally, we can look to return on invested capital, growth in sales or earnings, or overall business health.
With a return on equity, we have a metric that can help us measure a management’s ability to generate profits from every dollar of shareholder’s equity. After all, creating wealth from the money we invest in a company is what we are all after. We want great businesses that compound our money to generate greater returns.
This formula is great for comparing businesses in related fields, i.e. retail, tech, oil, biotech, etc. One word of caution, this formula is not perfect. There are problems with it, and we need to be aware of those when we are using these numbers to value a company.