This 3rd section of this series revolves around another significant element of Warren Buffett's hugely successful methodology - return on equity (ROE). Now, you may have heard the term "return on equity" before. It's not a relatively new concept, and it is one that is commonly used in finance. However, its importance must not be taken for granted.

Knowing what "return on equity" is only one part of the trick, the other part is knowing how to practice it to a greatly favorable effect. Warren Buffett uses the same fraction used by basically everyone in the industry, yet, he applies it in a style that no other person does, and this is the lesson that all investors should embrace.

First off, I would like to point to the definition of return on equity. ROE is equal to the net earnings of a company divided by shareholder's equity. ROE is also typically associated with the phrase "stockholder's return on investment." It discloses the rate at which shareholders are gaining money on their shares. Whether this rate can constitute a good return or not depends for the most part on the company and sector.

For example, a low ROE would be considered bad for a consulting firm because it is in an industry that doesn't require assets to start generating an income. On the other hand, a low ROE would be acceptable and even good in the oil industry because it is an industry that requires a lot of infrastructure to start generating an income.

However, the type of company or industry is generally irrelevant in this part of Warren Buffett's methodology (however, there is an exception which is explained in Part One). The reason why ROE is important to him is to see whether or not a company has consistently performed well in comparison to other companies in the same industry. The key word here is consistency. Buffett will always choose a company that has a consistent ROE over one that has an ROE that continuously fluctuates. In fact companies, which depend on the commodities such as oil and gas, are his least favourites and tend to have a largely fluctuating ROE. This point is explained in Part One of this series.

A sound time frame for studying the ROE of a company is 5 to 10 years. Such a period of time will give you a reasonable indication of the historical performance of the company. A good idea is to access past financial reports of chosen companies, most of which typically have their reports uploaded on their website. Additionally, it would be effective to enquiry and find the average ROE of chosen sectors to compare company performances.

The next part of this series will focus on another important element of Buffett's methodology - debt/equity ratio, and how many investors frequently overlook it. Watch this space!