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Focus on Return on Equity (ROE)
a stock analysis tutorial: use ROE to pick the best stocks

Long-term investors would fare better by focusing on a firm’s profitability rather earnings per share when researching a stock. 

Why? Because as you’ll soon see, one profitability measure, return on equity, can help you analyze a firm’s earnings growth prospects. But first some background. 

The headline grabbing earnings per share figure, which is net income divided by the number of shares outstanding, doesn’t tell you much by itself.

Suppose for example that two companies both earned $1 million last year. However company A did it on $10 million in sales compared to company B’s $100 million sales total. It’s clear that company A, with 10 percent return on sales ($1 million divided by $10 million), is more profitable than Company B with only a 1 percent return on sales. 

Money Managers Prefer ROE
While comparing income to sales is a valid measure, many professional money managers prefer return on equity (ROE), which is net income divided by “shareholder’s equity.” You’ll see why in a minute. The shareholder’s equity figure comes from the balance sheet and is a firm’s assets less its liabilities. The more familiar term, book value, is simply shareholder’s equity expressed on a per-share basis.

Revisiting the earlier example, suppose Company A and Company B’s shareholder equities totaled $20 million and $10 million, respectively. Then, Company A’s earnings translate to a 5 percent ROE ($1 million divided by $20 million) compared to 10 percent for Company B.

ROE Limits Growth Rate  
It turns out that a company cannot grow earnings faster than its ROE without raising additional cash. That is, a firm with a 15 percent ROE cannot grow earnings faster than 15 percent annually without borrowing funds or selling more shares. Of course firms often do raise funds by selling shares or borrowing, but at a cost. Servicing additional debt cuts net income, and selling more shares shrinks earnings per share by increasing the shares out total.

So ROE is, in effect, a speed limit on a firm’s growth rate, and that’s why money managers rely on it to gauge growth potential. In fact, many specify 15 percent as their minimum acceptable ROE when evaluating investment candidates.

Debt Muddles
Using ROE in this manner does have one drawback. Recall that shareholder’s equity is assets less liabilities. In this context, liabilities mean all monies owed by the firm including its long- and short-term debt. Suppose that two firms have the same assets. If so, the firm with the highest liabilities has the lowest shareholder’s equity. Since ROE is net income divided by the equity figure, the higher-debt firm shows the highest return on equity.

Consequently, you should take debt levels into account when comparing different firm’s return on equities.

You can use Yahoo’s profile report (quote.yahoo.com) to check any firm’s ROE and debt levels (debt/equity ratios). Get there by getting a price quote and then selecting Profile.

Screening for ROE
When I checked using Multex Investor’s (www.multexinvestor.com) screening program, I found 1,305 stocks with at least 15 percent ROE. However, to minimize the debt factor, I screened out high-debt firms by adding a maximum 0.5 total debt/equity ratio requirement. Doing that cut the passing total down to 593 stocks.

In my experience, very small firms are risky business, so I eliminated the smallest by specifying at least $50 million market capitalization and 12 months sales totaling at least $50 million. Adding those conditions reduced the number of qualifying firms down to 416 candidates, giving you a database of profitable stocks to which you can apply your usual analysis. Here's a link to the current results of that screen (you may have to click the link again after login). 

In addition to Multex Investor, you can search for high ROE stocks using the screening programs offered by MSN Money (moneycentral.msn.com) and Quicken (www.quicken.com). Of these, Quicken’s screener is the easiest to use, but the most difficult to find. From Quicken’s homepage, select Brokerage, then Quotes & Research, and then, Stock Ideas. From there select Stock Search and then Full Search. When I checked last week, specifying any revenue value flummoxed the program and caused it to return no candidates. Hopefully, that will be fixed by the time you read this.

Concentrating on truly profitable companies doesn’t assure success. Stocks move up or down for any number of reasons, especially in the short-term. Further research is required to determine if a company’s historical profitability and growth trends are likely to continue into the future.
published 12/1/2002 

 

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